Andrew Grice: The Week in Politics

Back Ken to hang on to his £11bn budget

London matters. The contest to become the capital's mayor in May is important because the winner will enjoy real powers and an annual budget of £11bn. It also matters hugely for national politics.

The main fight between Ken Livingstone and his Tory challenger Boris Johnson could be very close indeed. Gordon Brown and David Cameron will join the battle, even though both have some private reservations about their party's standard-bearer. "Ken is Ken," sigh Labour folk. "You know Boris," the Tories smile. It's an insurance policy in case Ken loses or Boris self-destructs. The stakes for the Prime Minister and Tory leader could hardly be higher and the battle for London is a proxy war between them. The Tories intend to throw £1.25m at their campaign. The result will be a defining moment in an important political year.

Elections to the former Greater London Council were a bellwether: whenever the Tories won control, they invariably won the following general election, and the same was true of Labour.

If "Red Ken" loses, the Tories will be able to claim Mr Brown is a dead man walking, that Labour's long spell in power is drawing to a close. A Tory defeat would be slightly less calamitous for Mr Cameron. But it would put a big question mark over whether his modernising project is paying dividends in the ballot box.

There are also parallels with the struggle between the two party leaders. Mr Livingstone, a left-wing hero who stood against his own party as an independent, now extols the merits of globalisation and has won over previously sceptical businessmen. As the incumbent, he is now portrayed as "serious Ken" against a Tory rival who was seen as gaffe-prone and high risk when he became the candidate but has been on his best behaviour so far. Labour is trying to frame the choice as between Mr Livingstone's experience and competence and the image and inexperience of Mr Johnson – which foreshadows the general election pitch of Mr Brown against Mr Cameron.

Livingstone allies say Mr Johnson has "never run anything", arguing their man, as his last job, wants to see through the Crossrail project which will boost the capital's public transport capacity by 10 per cent.

But Labour's strategy is not going according to plan. The "competence" tag is in danger of slipping because of allegations that "Ken's friends" have mismanaged funds allocated to projects by the London Development Agency (LDA). A lot of mud has been thrown at him and, in the past week, I suspect that some is starting to stick.

With a characteristic flourish, the Mayor alleges a "racist smear campaign" aimed at Lee Jasper, his race relations adviser, led by London's Evening Standard. Nothing has been proved yet, he argues. Police are investigating six grants – but only because the LDA called them in. Team Livingstone argues that the LDA can't be responsible for criminal activity after grants have left its hands. His aides say the unaccounted-for money represents less than 0.1 per cent of the LDA budget. One in 10 companies in London goes bust; the failure rate among firms backed by the LDA is much lower.

Opposition parties are gunning for Mr Livingstone, who has qualified his December statement that there was a "full audit trail". Rules are being tightened to rein in Livingstone advisers after Mr Jasper was accused of ordering LDA staff to save projects with which he was linked.

It is no coincidence that the chorus of criticism is getting louder as we approach the election, and I'm sure the mud count will grow in the next 12 weeks.

Not everyone in London reads the Evening Standard. Its daily dose of bad headlines may have less impact in the inner London boroughs which are Mr Livingstone's heartland. But every journalist in London reads the Evening Standard and it is influential in setting their agenda, which could be bad news for Labour as the national media turns its attention to the mayoral contest.

Mr Livingstone will campaign on his record on transport, the environment, crime and fostering good community relations. But he faces the fight of his life. Privately, Tories say Mr Johnson is pursuing a "doughnut strategy" of wooing voters in the outer London boroughs. His campaign is headed by Lynton Crosby, the tough Australian who ran the Tories' 2005 general election effort. He didn't win it but he gave Tony Blair a fright and maximised the Tories' core vote, which will be important in the London contest.

It is hard to see how the Liberal Democrat candidate, Brian Paddick, the former Met Police deputy assistant commander, can muscle in to a two-horse race. But, under the supplementary vote system, the second preferences of the people who back Mr Paddick could decide the contest, which is why Labour and the Tories are not attacking the Liberal Democrats.

At a recent London Chamber of Commerce meeting, businessmen were asked to put their hands up if they thought Mr Johnson could win. Lots of hands went up. But asked if they thought he would win, they kept their hands down. It is tempting to write Mr Livingstone off but, despite all the mud-slinging, he is not dead yet.