Margaret Thatcher was urged to abandon Liverpool to "managed decline" by her chancellor, newly-released National Archives files have revealed.
The confidential government documents, made available under the 30-year rule, reveal Cabinet discussions following the July 1981 Toxteth riots.
But then-Chancellor Lord Howe has said his short letter was misunderstood.
The riots, which lasted for eight days, followed the arrest of Leroy Alphonse Cooper on Selborne Street.
Some 460 police officers were injured during the disturbances, which began on 3 July.
More than 70 buildings were demolished or burnt down as tensions boiled over between the police and the district's African-Caribbean community.
While ministers such as the then Secretary of State for the Environment Michael Heseltine, were arguing for regeneration funding to rebuild the riot-hit communities, Sir Geoffrey Howe, now Lord Howe, thought it would be a waste of money.
He warned Mrs Thatcher "not to over commit scarce resources to Liverpool".
"I fear that Merseyside is going to be much the hardest nut to crack," he said.
"We do not want to find ourselves concentrating all the limited cash that may have to be made available into Liverpool and having nothing left for possibly more promising areas such as the West Midlands or, even, the North East.
"It would be even more regrettable if some of the brighter ideas for renewing economic activity were to be sown only on relatively stony ground on the banks of the Mersey.
"I cannot help feeling that the option of managed decline is one which we should not forget altogether. We must not expend all our limited resources in trying to make water flow uphill."
He acknowledged the suggestion the city could be left to decline was potentially explosive.
"This is not a term for use, even privately," he warned Mrs Thatcher.
But speaking to the BBC News Channel on Friday Lord Howe said: "I wasn't in any sense advocating managed decline. The whole of that is based on some misunderstanding of some short letter with specific objectives."
Lord Howe, who had been MP for the Wirral seat of Bebbington from 1964 to 1966, said he was only warning about depriving other areas of resources which might go to Liverpool.
He added: "Liverpool had been undergoing an unmanaged decline and we had to see if there were any devices to begin turning the decline around."
Lord Howe said Liverpool people should not be angered by his letter of 30 years ago as it was only pointing out that decline be managed until it could be reversed, adding: "Managed decline certainly wasn't an objective."
'Hatred of police'
As the government sought to respond to the situation in 1981, Mr Heseltine was despatched to Liverpool. He reported back by phone to Mrs Thatcher on 25 July.
The cabinet papers note: "Mr Heseltine considered the behaviour of the police in Liverpool 8 to be quite horrifying. They were not acting in a racialist fashion. They treated all suspects in a brutal and arrogant manner."
Mr Heseltine also said there were too many young recruits in the area and the local commander had a "fortress mentality".
Speaking to the BBC on Friday, Lord Heseltine said the idea of abandoning Liverpool was never an option.
He said: "It never really got any traction for the simplest reason that the cabinet minister responsible for so much of the policy that affected the city was me.
"I simply wouldn't countenance that you could say that one of England's great cities, a world city, was going into managed decline here."
He added: "I think we should be judged not by all the correspondence and all the arguments, and all the classic sort of responses you get from the Treasury.
"The judgement should be about did we do the right thing? And I haven't the slightest doubt we did do the right thing - and we learned a lot of lessons."
The cabinet documents also reveal the confidential meetings Mrs Thatcher had with civic, community and church leaders.
In a meeting with church leaders she said she was amazed at the hatred for the police in Liverpool 8.
The then Roman Catholic Archbishop of Liverpool Derek Worlock said although there was a "profound mistrust" of the police this was not the cause of the rioting.
Instead he told her there was a "silent colour bar" in a city where there were no black councillors and just eight black policemen.
'Time bomb ticking'
Lord David Alton, who was Liberal MP for Edge Hill at the time of the riots, told BBC Radio Merseyside: "Many people guessed that this was the impulse driving politics at the time.
"This idea of managed decline, that you can simply let one of the country's great cities slip into the River Mersey and opt for decay rather than renewal, shows an ambivalence to the north of England which still affects politics to this day."
He said he had made a speech in the Commons warning there was a "time bomb ticking away in the heart of the city as a result of the massive levels of unemployment".
He added: "It was like creating a museum of horrifying example that if you behaved in the way that they claimed that militants were doing in Liverpool, then the warning was that what was happening to Liverpool will happen to the rest of you.
"So I think it was used for very crude political purposes."