MILAN – The run-up to the economic crisis in the United States was characterized by excessive leverage in financial institutions and the household sector, inflating an asset bubble that eventually collapsed and left balance sheets damaged to varying degrees.

The aftermath involves resetting asset values, deleveraging, and rehabilitating balance sheets – resulting in today’s higher saving rate, significant shortfall in domestic demand, and sharp uptick in unemployment.

So the most important question the US now faces is whether continued fiscal and monetary stimulus can, as some believe, help to right the economy.

To be sure, at the height of the crisis, the combined effect of fiscal stimulus and massive monetary easing had a big impact in preventing a credit freeze and limiting the downward spiral in asset prices and real economic activity. But that period is over.

The reason is simple: the pre-crisis period of consuming capital gains that turned out to be at least partly ephemeral inevitably led to a post-crisis period of inhibited spending, diminished demand, and higher unemployment.

Counter-cyclical policy can moderate these negative effects, but it cannot undo the damage or accelerate the recovery beyond fairly strict limits.

As a result, the benefits associated with deficit-financed boosts to household income are now being diminished by the propensity to save and rebuild net worth.

On the business side, investment and employment follows demand once the inventory cycle has run its course. Until demand returns, business will remain in a cost-cutting mode.

The bottom line is that deficit spending is now fighting a losing battle with an economy that is deleveraging and restructuring its balance sheets, its exports, and its microeconomic composition – in short, its future growth potential.

That restructuring will occur, deficit spending or no deficit spending. So policy needs to acknowledge the fact that there are limits to how fast this restructuring can be accomplished.

Attempting to exceed these speed limits not only risks damaging the fiscal balance and the dollar’s stability and resilience, but also may leave the economy and government finances highly vulnerable to future shocks that outweigh the quite modest short-term benefits of accelerated investment and employment. Demand will revive, but only slowly.

True, asset prices have recovered enough to help balance sheets, but probably not enough to help consumption. The impact on consumption will largely have to wait until balance sheets, for both households and businesses, are more fully repaired.

Higher foreign demand from today’s trade-surplus countries (China, Germany, and Japan, among others) could help restore some of the missing demand. But that involves structural change in those economies as well, and thus will take time.

Moreover, responding to expanded foreign demand will require structural changes in the US economy, which will also take time. This is not to say that rebalancing global demand is unimportant.

Quite the contrary. But achieving that goal has more to do with restoring the underpinnings of global growth over three to five years than it does with a short-term restoration of balance and employment in the advanced economies, especially the US.

Today, the best way to use deficits and government debt is to focus on distributional issues, particularly the unemployed, both actual and potential.

In an extended balance-sheet recession of this type, unemployment benefits need to be substantial and prolonged. The argument that this would discourage the unemployed from seeking work has merit in normal times, but not now.

Today’s unemployment, after all, is structural, rather than the result of perverse incentives. Benefits should be expanded and extended for a limited, discretionary period. When structural barriers to employment have diminished, unemployment benefits should revert to their old norms.

Doing this would not only reduce the unequal burden now being carried by the unemployed; it would also help to sustain consumption, and perhaps reduce some precautionary savings among those who fear losing their jobs in the future.

Monetary policy is a more complex and difficult balancing act. A more aggressive interest-rate policy would likely reduce asset prices (or at least slow the rate of appreciation), increase adjustable-rate debt-service burdens, and trigger additional balance-sheet distress and disorderly deleveraging, such as foreclosures.

All of this would slow the recovery, perhaps even causing it to stall.

But there are consequences to abjuring this approach as well. Low-cost credit is unlikely to have a significant impact on consumption in the short run, but it can produce asset inflation and misallocations.

Much of the rest of the world would prefer a stronger dollar, fewer capital inflows with a carry-trade flavor, and less need to manage their own currencies’ appreciation to avoid adverse consequences for their economies’ competitiveness.

In short, the sort of monetary policy now being practiced for a fragile economy like the US will cause distortions in the global economy that require policy responses in many other countries.

From a political point of view, the crisis has been portrayed as a failure of financial regulation, with irresponsible lending fueling a rapid rise in systemic risk.

That leaves the rest of the real economy populated with people who feel like victims – albeit victims who, prior to the crisis, bought a lot of houses, vacations, TVs, and cars.

Unfortunately, that perception pushes the policy response in the direction of too much remedial action, even when the marginal returns are low.

What we most need now is support for the unemployed, stable government finances with a clearly communicated deficit-reduction plan, some truth-telling about medium-term growth prospects, and an orderly healing process in which balance sheets are restored mostly without government intervention.

Michael Spence is the 2001 Nobel Laureate in Economics, and Professor Emeritus, Stanford University. He chairs the Commission on Growth and Development.

Copyright: Project Syndicate, 2010.