Margaret Thatcher has undermined the Government's attempts to defuse the continuing storm over the Guardian's disclosure that the public finances have gone into the red.

In a veiled challenge to John Major to admit that he 'hadn't the guts' to cover his spending by higher taxes rather than higher borrowing, she has revived debates which rocked the Conservative Party two years ago.

Her intervention came as the shadow chancellor, John Smith, challenged Norman Lamont to issue a detailed refutation of the Guardian's disclosures or accept their truth.

Ministers have been nervous about the role Mrs Thatcher would play in the campaign, hoping that Sunday's demonstration of loyalty to Mr Major would prevent any 'off-the-cuff explosions' before she left for America at the end of this week.

In a little-reported off-the-cuff speech on Monday night in Cheshire, Mrs Thatcher stressed that her governments had believed in 'sound money' and had not only covered their spending with tax income, but had brought public borrowing down to a level where the national debt was being repaid.

'We took the view that you ought to cover your expenditure with your income - that was taxation - and therefore we ought to get the borrowing down. In my last four years, we had in fact got the borrowing down to nothing and we had a budget surplus and we were repaying the debt previous generations had accumulated. We did that because we Tories believed in something called sound finance.'

Although Mrs Thatcher reportedly entered a substantial caveat about government behaviour in a recession, her views still contrast sharply with the arguments Mr Major was putting forward to justify his projected £28bn public sector borrowing requirement before the Guardian disclosed that current government spending had now moved into the red.

She added that during the 1980-81 recession she too had faced the dangerous choice of higher interest rates or more inflation when she was struggling with a great deal of debt.

But the sting of Mrs Thatcher's remarks in Knutsford, Cheshire, in support of the Thatcherite former MP Neil Hamilton, who is seeking re-election, came in a direct response to the Guardian disclosures: 'I am sorry to give you a little bit of economics but I understand that taxation and borrowing have been in the news today,' she said, making it clear that her remarks were not referring to Labour's record in the 1970s.

'Those who have been boasting that they have the burden of tax lower have got to say that they had not the guts to cover their expenditure by taxation and in fact they covered it by borrowing and therefore handed on the burden to future generations.'

She rammed the message home by reminding Mr Major that she had 'the strength of will to say 'no' to public expenditure even though it was for very good causes.'

She also repeated her Grantham-spun view of economics: 'I took the view that every family has to live within its means. Every company has to live within its means or borrow a small amount but can service the borrowing. Therefore governments ought to be able to give an example and live within their means.'

The Government's rebuttal of the Guardian allegations that it is borrowing to consume has rested on the fact that public sector net asset creation, the widest definition of investment - which includes spending on items such as tanks - will amount to £30bn next year. This is greater than the £28bn forecast for the public sector borrowing requirement.

This measure shows the Government's current finances slipping into the red the following year, however. Government borrowing is forecast to rise to at least £32 bn in 1993-4, but falling defence spending means that net asset creation will not rise by as much.

The former Conservative communications director, Brendan Bruce, said after her Sunday performance: 'Mrs Thatcher may be a loose cannon but she is firmly secured to the deck and facing the enemy.' However, Labour is interpreting her speech in Cheshire as an indication that she has broken free of the ropes.

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