Little room for manoeuvre, whoever wins

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The City's reaction to the Tory leadership election shows every sign of turning into a test case of the power of markets to enforce discipline on errant governments. Markets believe that, whatever the outcome of the contest, it will lead to the adoption of a "cut and run" strategy. Yet its attack of nerves could mean that whoever wins will find it difficult to loosen policy any further than Kenneth Clarke already had in mind.

On Monday, gilts and shares were buffeted most of all, but yesterday the storm moved to the foreign exchange markets. The pound touched its all-time low on the Bank of England's trade-weighted index during the day. If selling pressure persists, it won't be long before it hits a new low against the German mark.

A plunging gilts market may discomfit governments - the timing of the auction of pounds 2.5bn worth of stock tomorrow could hardly be more embarrassing. But as ever, it is the spectre of a falling pound that will scare ministers. The classic response to a falling pound - a rise in interest rates - is almost certainly ruled out in the next few days by political imperatives. Neither John Major nor Mr Clarke - who must be contemplating throwing his hat into the ring if the Prime Minister falls at the first round - is intent on political suicide. Even if it were implemented it could prove counter-productive in much the same way as the hikes in interest rates proved to be on Black Wednesday.

Instead, sterling will be left to drift with, no doubt, some helpful intervention by the Bank of England to keep things on an even keel. But all this will do is to buy time. Come the eventual knock-out round and the new Tory leader could inherit a bleak economic landscape. As the minutes of that now notorious meeting between Mr Clarke and Eddie George on 5 May made clear, the Governor's main argument for a rise in interest rates centred on the inflationary impact of the fall in sterling earlier this year. It would be illogical for him not to press the case with further vigour if the pound were to fall still further.

Mr Clarke was able to see off Mr George with surprising ease for a number of reasons. The dollar came off the floor, lifting sterling with it, and most of the subsequent economic indicators for the UK backed the Chancellor's viewpoint rather than the Governor's. However, a subsequent confrontation with Mr George, maybe with a new Chancellor, could meet with a very different reaction from markets. As before, external events may help to ease the dilemma. After yesterday's plunge in consumer confidence in the US, a cut in interest rates at next week's meeting of the Federal Reserve looked even more likely. Many observors also anticipate a further cut in German rates before too long.

But a run of luck can only go so far. The Tories may find that a leadership contest in which tax cutting has come to the fore could backfire badly. It could well create a market counter-reaction that imposes even greater orthodoxy on them when they get back to trying to govern the country.