A 1922 Royal Commission called them "touts". They went around, during Lloyd George's premiership, selling honours for hard cash. It was a hugely lucrative business which is thought to have enriched the great Liberal leader by tens of millions of pounds in today's money. Lloyd George's supreme tout was Arthur Maundy Gregory, an actor-manager turned blackmailer and spy, who brokered peerages and knighthoods on the PM's behalf, at up to GBP120,000 a time in old money.

Gregory was implicated in the disappearance of a former MP, Victor Grayson, who had tried to expose the scandal. He also had a hand in getting the forged Zinoviev letter published, ruining the Labour Party's chances in the 1924 General Election. But Gregory continued peddling honours for money right up until 1932, when he was arrested and charged under the 1925 Honours (Prevention of Abuses) Act.

The chief honours fixer certainly knew where all the bodies were buried. But by pleading guilty he received a minimal two-month sentence and a GBP50 fine. By blackmailing the rich and ennobled in return for his silence, Gregory defrayed these costs many, many times over. After prison, he was even sent off to live in Paris on a pension of GBP2000 a year, paid for by some of his former clients, the deal negotiated by a prominent Tory, himself later knighted. Gregory remains, to this day, the only person convicted under the 1925 act.

But the act was invoked again this week when Lord Levy, Tony Blair's confidante, Middle East envoy and party fund-raiser-in-chief, was arrested and questioned, over two days, by police investigating possible links between secret loans made to the Labour Party before the last election and nominations for honours. Levy is the 48th person to be interviewed, 13 of them under caution. What once looked like a forlorn complaint by SNP member Angus MacNeil has turned into a major inquiry, spanning both Labour and Tory supporters.

Some papers are already with the Crown Prosecution Service. Tony Blair may be next for the Met hotseat. Indeed, since the drama of his tennis partner's arrest, most of the speculation has swirled around the Prime Minister himself. If Levy is eventually charged, could Blair still cling to power? If Levy does go down, would he drag the whole New Labour project down with him? The key to these and countless other questions must be the police inquiry's ability to establish clear links between the channelling of previously undisclosed loans to political parties and the promise of honours in return.

In Maundy Gregory's day, there was a willing seller of honours (Lloyd George) and countless eager buyers of anything from a viscountcy (up to GBP120,000) to a humble Order of the British Empire (GBP100). Gregory was even set up in an office in Whitehall, with assorted flunkies, to grow his flourishing trade. The strong allure of what the physician Lord Winston once dubbed "the fluke of patronage" and the inadequacy, for many, especially in the world of business, of what Sir Robert Peel once called "the distinction of an unadorned name" has persisted ever since. But it is harder to prove criminal culpability when the proceeds are not going straight into someone's back pocket.

We have had plenty of honours scandals since the 1930s. Indeed, in its interim report on this issue, published yesterday by the House of Commons public administration select committee, but rather eclipsed by Lord Levy's second day with the police, the MPs admit: "There has always been a close correlation between party funders and the distribution of honours."

The most shocking feature of Harold Wilson's so-called lavender resignation honours list in 1977was the inclusion of minor businessmen, like Lord Joseph Kagan, later convicted of false accounting, and Sir Eric Miller, who became embroiled in a DTI inquiry and later shot himself. Between 1979 and 1992, according to the Labour Research Department, only 6.2per cent of British companies gave money to Margaret Thatcher's Tories. But more than 50per cent of the peerages for services to industry she handed out went to executives from donating firms.

In her resignation honours list, according to yesterday's select committee report, an honorary knighthood for Rupert Murdoch was removed, under pressure from the independent committee charged with scrutiny at that time. Yet, in his evidence to this inquiry, the current chair of the Appointments Commission, Lord Stevenson, didn't even know whether he and his colleagues had the power to scrutinise future resignation lists.

It is high time the whole disreputable business was sorted out. There may be a case for a honours system, designed to recognise individual merit, achievement or service. I am not convinced there is. But if it is needed, it should not be under the patronage of Prime Ministers. It should be the work of a wholly independent honours commission. And it should have nothing to do with sending people to serve in that Other Place, as part of our legislature.

Nor should any part of our present honours system, including life peerages, be contingent on making financial donations to this political party or that. As the bank overdrafts of all the main parties continue to balloon - Labour and the Tories are both said to be GBP30m in the red as I write - the temptation to link donations to patronage can only grow.

Labour and the Tories are both caught up in the current loans scandal, being investigated by the Metropolitan Police. The Liberal Democrats have had their own headaches over their biggest single donor, expatriate Scots businessman Michael Brown, who backed them with more than GBP2m before the last election. Brown has now been extradited from Spain, facing charges of fraud, forgery and obtaining money by deception.

What are the alternatives? Many leading politicians will point to urgent need for a consensus on state funding of political parties, in the interests of a thriving democracy. However, with politics in such low esteem among voters and participation rates falling, that is a very tough sell in the short term.

Parties can still appeal to supporters with the wherewithal and commitment to feel proud about putting funds where their political beliefs lie, as Labour did in a full-page ad in yesterday's Times, signed by, among others, the actors Brian Cox and Eddie Izzard, Sir Alex Ferguson and the financier Sir Ronald Cohen.

But any honours coming their way should be decided by others, free of party ties. And if that leaves parties with funding shortfalls, let them do what others have to do and live within their means.