Risk of 'cut and run' remains the real danger

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In circumstances like these, financial markets tend not to be particularly sophisticated readers of the tea leaves. With overseas investors in particular, there is an inclination to put the worst possible interpretation on events; what they see is the final death throes of a government, an imminent end to 16 years of Tory rule. Regardless of whether this would in practice be the disaster for markets that many assume, this seems in fact a quite unlikely outcome of the present leadership contest.

The markets have had it wrong once already in the short duration of this leadership contest. Yesterday's knee-jerk reaction to the Redwood factor could prove equally misguided. The immediate reaction to John Major's extraordinary move was seen as positive, a chance to clear the air. It should have been apparent from the outset that this was a gamble born of weakness. John Redwood's decision to throw down the gauntlet does not change that calculation one iota: it simply highlights it.

Now the talk in the City is that the contest might bring about an early general election. Under this scenario, the new leader would face an immediate vote of no confidence, which he would lose. Though the new prime minister would indeed have a slim majority, this hardly seems plausible. Conservative MPs may be many things but they are not lemmings. The reason for this leadership election is that so many in the centre were panicking about losing their seats. Whatever the outcome of the contest, they are likely to rally behind a new leader who will have to find common ground.

Europe is the great faultline, but there is nothing to stop a successor to Mr Major camping the party on territory already staked out by Mr Major. "Wait and see" will continue to be the compromise on Europe, with stress placed on the opt out and a talking up of the chances that a sceptical German public will eventually scupper the whole enterprise.

The real danger remains the one that was already on the cards: a "cut and run" policy with sound finance and money thrown to the winds. Since Mr Clarke had already served notice of his effective loosening of the inflation target, the danger here is one of degree rather than kind.

The big question is just how much discretion a new Tory leadership will have to relax policy. The markets, we are constantly told, are all-powerful constraints on politicians' ability to engineer an electioneering boom. What a paradox then that it is markets, rather than commentators, that are so sceptical that boom and bust is a thing of the past.

None the less, the reality is that whatever the outcome of the leadership contest, a new leadership will face the same harsh constraints. As the Treasury economic forecasts tomorrow are expected to reveal, public borrowing is falling less than had been anticipated in November. Inflation, too, is likely to be pushed up to a more realistic figure than 2.5 per cent for the final quarter of the year.

Yes, there is almost certain to be a further relaxation of policy after the contest. But don't exaggerate the scope for a huge change: the penalties that would be exacted in the markets would be too great.