Business Comment: The markets were right to smell a rat

John Major's leadership gamble throws into sharp perspective the political risk of investing in the stock market - witness the sell-off in gilts. In the past, that political risk would have been the prospect of a Labour government. Now it centres on the desperate actions of a desperate government seeking to avoid a Canadian-style wipe-out in the polls.

The main question for financial markets as the leadership contest develops is whether the end result will be to make the Conservatives even more reckless than already seems likely. Or could it reduce the pressure to risk all on an electioneering boost to the economy?

One scenario is that John Major emerges strengthened from the contest. He sees off a stalking horse candidate with few abstentions in the first round. The boil of party discord is lanced and he is able to impose his will on backbenchers and Cabinet alike. Since party disunity is always anathema to the electorate, this would enhance the Tories' dismal standing at the polls.

A reinstated and more powerful prime minister would continue with the existing strategy which offers the prospect of some tax cuts and a willingness to take some risks with inflation.

The only trouble is that this scenario seems the most unlikely. The notion that there will be few abstentions in the first round underestimates the seething discontent with Mr Major's leadership. Backbenchers who have yearned to get rid of him without striking the first blow have been handed the chance on a plate. They are unlikely to turn it down.

Assume then that Mr Major is fatally wounded in the first round and then withdraws to allow a contest between the two most likely contenders, Michael Heseltine and Michael Portillo. The betting is that Mr Heseltine would win and the party would rally round him. A new start and a more decisive leader would again enhance the Tories' standing at the polls.

But under this scenario, it is much less likely that Mr Heseltine would "do the right thing" as far as the markets were concerned. His instincts have always been expansionist - unlike Mr Major, who still bears the stamp of Treasury orthodoxy after his long stint there. Furthermore, a Hezza victory would come after a bruising contest that would lay bare the European fault line in the party. What could be more healing than the balm of big cuts in direct taxes - cuts that a new leader could much more readily offer without loss to his credibility?

The chances of a "cut and run" strategy are also higher in the other possible results, such as a broken-backed re-election of Mr Major in which he fails to win a ringing new mandate from the parliamentary party, or a surprise breakthrough by Michael Portillo.

What this suggests is that the markets were right to smell a rat yesterday. The inflation target has already been shifted in some nifty footwork by Kenneth Clarke and a successful confrontation with Eddie George. Now the objective to move towards a balanced budget seems likely to become a lot less pressing. For whatever the outcome of the leadership contest, one thing is clear: the chances of achieving giveaway tax cuts by matching cuts in public spending are as remote as a Tory victory at the next election.