For the Pound's Sake, Don't Write May a Blank Check

(Bloomberg View) -- By calling a general election on June 8, U.K. Prime Minister Theresa May is asking Britain for a stronger mandate to steer the country through Brexit negotiations. With a larger majority, she says, her government would be able to secure a better deal, improving the economy. The policy trajectory set so far suggests otherwise. 

The vote to have Britain exit the European Union highlighted deepening rifts across the country -- between the old and the young, the rich and the poor, the North and the South. May's proposals, which focus on lower taxes funded by cuts to education, health care and security, are likely to make Britain an even more divided kingdom. 

Once among the poorest European countries in the 1970s in terms of gross domestic product per capita, the U.K. flourished after joining the EU by gradually becoming its hub for finance and services and attracting global talent. It became, as a Chinese businessman said, "the door to Europe. But without Europe, it's just a door." Thanks to finance and services, Britain outgrew other countries during the financial boom of the 1980s and 1990s and until the 2008 crisis. Yet this came with rising inequality and deep economic imbalances. Finance accounts for almost 8 percent of GDP and London counts for 22 percent. The top 1 percent of taxpayers produces 27 percent of the income, according to the Office for National Statistics, the highest among developed countries after the U.S. Corporate profits have grown but wages have stagnated along with productivity. Household debt is back to the highs of 2007. Almost four million children live in poverty. 

The English patient was sick long before the Brexit referendum. The illness is a mix of longstanding economic imbalances, lack of productivity and rising inequality. Today's Conservative agenda pledges to make Britain a "great meritocracy," giving everyone a fair share of opportunity. Beyond the slogans, however, economic policies go the other way. On the budget, the main focus remains the deficit. On industrial policy, Tories pledge to address productivity by investing in education and revamping investment in the North. 

The last two are key measures to address Britain's declining productivity and rising inequality. Yet raising investment while balancing a growing deficit are as compatible as pushing a car's accelerator while pulling the handbrake. The Tory manifesto says it will make up the budget shortfall with revenue from fracking and private investment funds. These targets are unrealistic, as the Institute for Fiscal Studies recently said. Labour's pledges to increase National Health Service funding and cut tuition fees by raising taxes also do not balance out. But at least the opposition's policies are on the right side of history, focusing on inclusive growth.

Today, Britain's economy is humming, supporting the idea that Brexit may not be so bad after all. Yet this is thanks to three fortunate factors. First, the pound has depreciated by around 20 percent since the Brexit referendum was announced, helping exports. Second, U.K. consumers have been spending and borrowing up to pre-crisis highs. Third, the rest of Europe is growing faster, at around 2 percent. This suggests the economy is running to stand still.

We estimate Brexit will shave 140 billion pounds ($180.7 billion), or 7.5 percent, from U.K. GDP over the coming years, including direct costs from the relocation of financial services and faster inflation. A no-deal Brexit would be even more destructive. It would push the pound below $1.20 and the inflation rate above 3 percent. That will squeeze consumers' income and, over time, savings, as the Bank of England's quantitative easing continues  to keep Gilt yields well below inflation.

Countering this economic fallout requires a far-reaching plan of action. To become stronger and fairer, Britain needs a new growth model, one that focuses on investment and not austerity, on productivity rather than asset prices, making quality education available based on talent and on building new homes rather than boosting the price of existing ones. 

With her multiple U-turns, May has shown she doesn't have a plan. Her threats to be "bloody difficult," to withdraw security support from the EU or to walk away from negotiations are neither useful nor credible. To the surprise of Brexiteers, the U.K. now faces a united Franco-German front led by French President Emmanuel Macron and German Chancellor Angela Merkel.

The prime minister may have used an opportunistic moment to induce voters to strengthen her hand, but the British people deserve better. Beyond their slogan-filled manifesto, Tory policies are likely to serve more of the same: economic division for many and opportunities for few. On June 8, the U.K. should not write May a blank check.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Alberto Gallo is partner at Algebris Investments and portfolio manager for the Algebris Macro Credit Fund.

To contact the author of this story: Alberto Gallo at macrocredit@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.