Steve Richards: However it was handled, Lord Levy's arrest can only damage the Prime Minister

Even if it all comes to nothing, doubts about prime ministerial probity will be an issue of the moment

Perceptions matter in politics. Yesterday, Tony Blair's main fundraiser and close friend, Lord Levy, was arrested and released on bail. That single bald sentence, even though it is one that raises many questions, will have alarm bells ringing in Downing Street and beyond. However noisy the protestations of innocence, whatever the details that may follow, yesterday's developments look bad for Mr Blair and those in the upper echelons in the Labour Party.

Perhaps it will be only a fleeting perception. Yesterday's arrest may come to nothing at all. After his release on bail, Lord Levy issued a statement stressing his innocence and expressing anger that the police felt it necessary to arrest him. It is quite possible that in months to come questions will be asked of the police and the way officers have approached this investigation. This is the second arrest in relation to funding and peerages. In both cases, those who were arrested wondered why they had been treated in a way that guaranteed the most spectacular news coverage.

That is for another time. For now, yesterday's arrest conveys a more urgent message. It signals that the police investigation into cash for peerages will be a loud background hum over the next few weeks and months, a period that was always going to be turbulent for the Prime Minister. The media's appetite is whetted. It will pose further questions. The theme is deeply damaging. Even if it all comes to nothing, sleaze and doubts about prime ministerial probity, will be an issue of the moment.

There could be no worse topic to compete with the other damaging questions. Can or should John Prescott hang on as Deputy Prime Minister? Is he merely being kept in place so that Mr Blair can continue in his post? These are subplots to the overriding political question: Is Mr Blair's continuing presence in Downing Street damaging his government and Labour's prospects. In some quarters of the Labour Party that question will be asked with a renewed urgency.

There are, however, grounds for caution. Perceptions matter hugely in politics, but so does the reality. The other main parties need to watch developments with care. They will not be leaping with joy at Mr Blair's discomfort. Their turn will come too. The Conservatives sought loans from business leaders. The Liberal Democrats have also been in trouble recently over party funding. Last night the shadow Home Secretary, David Davis, understandably sought to make mischief in his interviews. He noted that the police investigation was moving close to Mr Blair, but that was more or less it. Mr Davis was exercising restraint. He has killed off ministers before. He knows how to do it. He did not go for the kill last night. Presumably he senses that questions will be asked of his own party.

There is also no evidence yet that anyone has broken the law. The earlier revelation that Lord Levy advised a donor that he did not have to declare a loan to the committee that scrutinises peerages was damaging, but did not reveal an illegal act. To prove that someone broke the law, the police will have to demonstrate that donors were offered peerages as a reward.

But even if nothing as dramatic arises from the police investigation, one conclusion can be made already. New Labour's relations with business leaders have led them into nightmarish political difficulties. Mr Blair's antennae were fiendishly sharp in his dealings with the trade unions. Labour's relations with the trade unions had become a near-fatal problem in the late 1970s. Mr Blair resolved never to make the same mistakes as previous Labour prime ministers.

The past is a fickle guide. Partly as a result of Labour's errors then, Mr Blair regarded his close relations with business leaders as a form of vindication. Old Labour was seen as anti business. New Labour would become the party of business. Evidently, this has led Mr Blair down a different dangerous path, one that could prove as treacherous as the one followed by his predecessors as they struggled over their close relations with unpopular trade union leaders. When historians explain the fall of New Labour, or at least this phase of New Labour, its relations with business will play a key part in the narrative.

There will be two consequences in terms of policy. Moves to address party funding will become more urgent. No future or existing leader will want to go through this nightmare. State funding looks more likely than ever. The reform of the Lords will also acquire a new importance, although it will be viewed through an unfortunate prism. Constitutional reform should be addressed on its merits, not in reaction to a crisis because various prominent individuals have been arrested or face the prospect of arrest.

Indeed, it must be doubtful whether Mr Blair is best placed to lead this particular charge. Lords reform is a minefield. The new leader of the House, Jack Straw, plans to bring forward new proposals by the end of the year. Opponents will argue that they have been introduced as an act of desperation, rather the political principle. There are many opponents to reforms in the House of Lords, some armed with potent arguments, well beyond their self-preservation.

But it is the broader politics that remains explosive. Ever since the party's treasurer, Jack Dromey, declared that he knew nothing about the loans that had been negotiated before the last election, there was a sense of trouble ahead. Someone close to Lord Levy told me last month he was concerned about the police investigation and determined also not to be made a scapegoat. Even then, before yesterday's arrest, there were some senior figures in Downing Street and in the Labour Party who were worried about the implications of this police investigation. They will be more worried now.

Ever since the last election, Mr Blair has resolved to focus on policy. He ignores much of the frenzied speculation about when he will depart. In recent days, his schedule has included a seminar on the relations between the state and users of public services in preparation for a major speech this month. He has given interviews on nuclear power and held meetings about the reforms of the Lords. At Prime Minister's Question Time yesterday he claimed the dividing line was between a government willing to focus on policy and a Conservative Party that was vulnerable when it sought to come up with its own proposal.

Yet there comes a point when events overwhelm long-serving political leaders. Even the most agile leaders are no longer able to set the agenda. Instead, unlikely topics take a hold. If in the heady summer of 1997 Mr Blair or anyone else had suggested that one of those topics would be the arrest of Lord Levy, there would have been much disbelieving laughter. Yesterday, Lord Levy was arrested. No one was laughing.

s.richards@independent.co.uk