Page 10 One could easily test the hypothesis that providers of small amounts of money would require an exposed agent. On income tax returns a field could be created where taxpayers could voluntarily indicate the amount of money they would be willing to invest into projects via the government. The money could be collected with the tax bill and returns from such voluntary investment could be automatically credited to future tax bills.

Somehow we might expect that not too much money would be raised that way. If so, this would support the view that the financial advantages of government finance are based on coercive powers and not on a superior system to exploit the low cost of risk-bearing of tiny investors. In fact, it would become clear that the low cost funds cannot be tapped unless the intermediaries have good incentives to use the money well, which gives by necessity rise to significant costs of risk-bearing on the part of the exposed intermediary. In turn this requires risk-adjusted rates of return on financial instruments. Crucially, we cannot consider the cost of funds independent of the incentive system, under which intermediaries collect them. This is similar to modern theories of intermediation, which emphasize the monitoring problem of small investors in intermediaries and not only optimal risk diversification issues (Hellwig 1990).

# **111.4. Incentives of the government as intermediary**

For the Arrow and Lind argument to still hold the government as intermediary would need to have better incentives to invest well than private parties. Arrow and Lind state "that many of the uncertainties which arise in private capital markets are related to what may be called moral hazards. Individuals involved in a given transaction may hedge against the possibility of fraudulent behavior on the part of their associates. Many such risks are not present in the case of public investments and, therefore, it can be argued that it is not appropriate for the government to take these risks into account when choosing among public investments." It seems Arrow and Lind assume that the government will in fact do what it ought to do, namely act benevolently and efficiently. Clearly that is not the case in practice for many governments throughout history. So Arrow and Lind may be right that there are low cost funds out there, but they may err in jumping to the conclusion that the tax system is a good way of tapping them.<sup>6</sup> But maybe one could argue that government should collect "cheap" money and pass it on to projects, which have private sponsors, who have first-risk-of-loss and will want to invest well. This line argument may be seductive at first sight. However, any such rule "invest only when there is serious private equity" or "invest only pari passu in senior debt and not more than 5 percent of total ]6 We know that in some cases people are willing to invest in opportunities with negative expected values, for example lotteries. If one could create a lottery for project finance this should lower the cost of funds. After investing into a project investors lots could be drawn assigning very high proportions of the project return to some investors and nothing to others. The fact that we don't see such mechanisms may have to do with the fact that abuse under normal lotteries is easier to monitor. But maybe there are unexploited ways of setting up mutual funds here. The equity contributors to projects like Eurotunnel may in fact have been driven by a lottery spirit.