What Determines the Government’s Funding Costs when r=g? Unpleasant Fiscal Asset Pricing Arithmetic

Using MBA textbook finance, we look at three simple examples to illustrate why the r-g measure of the fiscal cost of deficits is incomplete. We start by considering the case of risky government debt. Second, we consider the case of risk-free debt. Third, we allow for convenience yields. In each of these cases, Blanchard’s gap is incomplete at best. Fundamentally, the government’s cost of funding is determined by the riskiness of its spending, its tax revenue and, if relevant, the seigniorage revenue.