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Stephen King: Cameron cannot look to the Thatcher years for his inspiration

No pain, no gain. That is the message coming from the Conservatives and, for that matter, from Labour too. The UK's public finances are in a parlous state. Spending is going to be slashed. Taxes are going to rise. And our political leaders, both current and those-in-waiting, are hoping that a dose of tough medicine now will form the foundations of the next recovery.

How might the medicine work? After all, reducing government borrowing doesn't sound terribly Keynesian and, with the UK economy only now beginning to stabilise after a nasty recession, a sudden tightening of the fiscal screws might threaten an even bigger slump.

Nevertheless, reducing government borrowing hasn't always been an entirely mad proposition. Geoffrey Howe, egged on by Margaret Thatcher at the beginning of the 1980s, did it despite the opposition of the 365 economists who wrote to The Times in protest. In hindsight, he got away with it. The UK economy eventually recovered. People stopped humming along to The Specials' "Ghost Town" (1981) and, instead, strutted their stuff to Wham's "Club Tropicana" (1983). Big increases in unemployment in the early 1980s were followed by big falls in the late 1980s. And Mrs Thatcher, helped initially by General Galtieri, went on to win the 1983 and 1987 general elections.

The improvement in the UK's fortunes as the 1980s progressed is, at first sight, puzzling. According to the economic conventions of the day, high unemployment should have been dealt with via loose, not tight, fiscal policy. The Conservatives did the exact opposite and ended up winning election after election. Are we about to see history being repeated?

Apart from taking on the unions and winning, which led to a massive reduction in days lost through strike action, Tory policies in the 1980s delivered four new sources of stimulus which, at the time, went largely unrecognised, even by the Tories themselves. The first was a sustained fall in inflation. The second was financial deregulation. The third was a reduction in the size of the state: reduced government borrowing and a commitment to keeping government debt under control led to a sustained drop in interest rates which "crowded in" private-sector investment. And the fourth was a persistent fall in the exchange rate following the extraordinary highs reached in the early years of the Thatcher administration.

Excluding mortgage interest payments, inflation dropped from a high of around 20 per cent at the beginning of the 1980s to a low of a little over 3 per cent. Households reacted to lower inflation by saving less and spending more. With lower inflation, the real value of savings was more easily preserved, thereby reducing the frequency with which nest eggs had to be topped up to compensate for the eroding effects of inflation. Consumer spending blossomed, helped along by the financial deregulation which allowed people to get hooked on borrowing. Credible attempts to bring government borrowing to heel, partly through a drop in the share of public spending relative to GDP, led to a sustained drop in nominal long-term interest rates.

As the budget deficit fell and interest rates came down, the exchange rate dropped. Between 1980 and 1985, the pound lost more than half of its value against the dollar while, between 1980 and 1990, the pound lost almost half its value against the Deutsche Mark. In response, exports ended up a lot stronger than might otherwise have been the case.

David Cameron and George Osborne are unlikely to be quite so lucky. Whereas inflation was high at the beginning of the 1980s, it is now very low. There is no obvious mechanism, therefore, to persuade households to start spending more: indeed, given the lack of stock-market progress over the last decade, households may now choose to spend less, in an attempt to rebuild their nest eggs and to pay off existing debts.

Rather than seeing financial deregulation, we're more likely to see financial re-regulation in the months ahead. The ease with which consumers will be able to get access to credit may shrink even further. With interest rates already very low, reductions in government borrowing are unlikely to have any real impact in kick-starting corporate activity: "trickling in" is more likely than crowding in. Meanwhile, although it's already fallen a long way, a repeat of the declines seen in the 1980s would require the pound ultimately to fall through parity against the dollar and go well below parity against the euro. Think how expensive your foreign holidays would be then.

These constraints reveal a key distinction between the current crisis and the difficulties confronting the Tories at the beginning of the 1980s. Back then, the major problems were the inefficiency of resource allocation across the economy as a whole, the absence of incentives to work hard, and a set of industrial relations which had stultified economic progress. Reforms in these areas had the potential to raise economic activity: for too long, Britain had been a second-rate economy, unable to realise its potential. Market forces, lower taxes and labour-market reforms were all part of a package which ultimately raised the UK's trend rate of economic growth, particularly relative to its competitors in Europe.

Today's problems are different. It's not so much that Britain has failed to live up to its potential. Instead, in recent years, we have collectively spent beyond our potential. Big increases in public spending depended on big increases in tax revenues and they, in turn, depended on excessive risk taking and bumper profits within the financial system. The challenge today lies not so much in boosting supply but, instead, in crimping demand. Following the 1981 recession, the UK enjoyed a relative swift economic recovery. There is unlikely to be any repeat this time around.

All is not lost, however. At the macroeconomic level, action to reduce the budget deficit may still have a modest longer-term beneficial effect on private-sector activity. If companies and individuals see no sign of fiscal consolidation, they have every reason to believe the government will eventually have to shove taxes up even more dramatically, engage in even bigger spending cuts than are currently being threatened, or start printing money in a bid to reduce the real value of its nominal debts. The uncertainty generated by these threats may lead to even bigger increases in savings by households and companies, thereby leaving the economy permanently moribund. Japan's experience over the last 20 years offers an excellent example of this kind of behaviour.

At the microeconomic level, there's a strong case for rethinking the measurement of public spending to release resources for other uses. Conceptually and practically, this is a difficult issue. We tend to think about public spending as if the inputs and outputs are the same thing. What matters, however, is not the number of nurses or hospital beds but, instead, whether people's health is improving: the ban on cigarette smoking in public places may have required little in the way of health inputs but it may deliver a significant health "output".

The focus on inputs also leaves us unable to assess whether those inputs are being used efficiently. My wife's GP still won't have anything to do with e-mail and the internet or, indeed, with any kind of keyboard, preferring to dictate what others will eventually type: almost certainly, the GP is treating fewer patients as a result. Perhaps I should adopt a similar approach. I shall scribble my next article with the use of quill and ink and then deliver it to The Independent via carrier pigeon. At least that way my copy won't be held up by the postal strike.

Stephen King is managing director of economics at HSBC