Scottish Economy Watch

The spin and hype from the 'yes' and 'no' campaigns after the publication of the Government Expenditure and Revenues Scotland (GERS) was enough to make the eyes water.

In 2011-12 the estimated net fiscal balance (with a geographical share of oil) is -5% of GDP compared to the UK's balance that year of -7.9%.

The 'yes' campaign and supporters of independence argue that GERS demonstrates that Scotland's fiscal position is better than the UK. The 'no' advocates highlight the importance of north-sea oil revenues amounting to £10bn, or 17%, of estimated current revenue. North-sea revenues are volatile and projected by the OBR and others to be in long-term decline. The size of Scotland's net deficit is likely to worsen both absolutely and relative to the UK.

In a sense both sides of the campaign are correct, although for the Scottish Finance Secretary John Swinney to say that the figures showed that Scotland was better off to the tune of £824 per person is stretching it a bit. We didn't have a bigger surplus but a smaller deficit, courtesy of oil revenues, of £7.6bn, or 5%.

The 'no' campaign also need to be reminded that there will be policy options open to an independent Scottish government to help reduce spending, raise taxes and lower the deficit e.g. less defence spending, policies to stimulate migration that will mitigate Scotland's developing demographic problem etc. GERS offers a static picture with the finances likely to evolve after independence.

Yet, a deficit will still have to be funded. And what is important is not just the size of the deficit but the cost of funding it i.e. the cost of borrowing.

As I noted in this detailed post a newly independent Scotland is likely to have higher borrowing costs than the UK for three reasons.

First, a recently independent Scottish government, with no previous experience of and reputation for fiscal management will have a credibility problem. That problem is likely to be worsened by both the high levels of debt that will be inherited by the new Scottish state and the fears of a continuing structural deficit, which will have to be financed.

Secondly, Scotland is much smaller relative to the UK and its finances are likely to be more volatile because of its size. According to OECD evidence small countries tend to pay a risk premium on their borrowing simply because of their size. Moreover, Scotland's dependency on oil revenues is an additional factor increasing the risk of volatile tax revenues and hence the demand for a risk premium by purchasers of Scottish government bonds.

Finally, an independent Scottish government that chooses sterling, for the very good reasons noted above, will effectively be borrowing in a foreign currency. The implication of this is that the financial markets will perceive Scotland to be a greater default risk compared to a state that can meet its obligations by printing its own currency.

So, we cannot simply judge the health of an independent Scotland's public finances by the scale of its likely deficit, the cost of borrowing is as important.

It's not just size that matters.