It’s not often we agree with New York Times hack and Nobel Prize winner Paul Krugman. He has been a harsh critic of Team Obama’s policies. The problem is he argues for doing more, not less. However, in a recent New York Times article “The Krug” actually said something that made sense.

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again — literally.

For this is the third time in history that a major economy has found itself in a liquidity trap [...]

The first example of policy in a liquidity trap comes from the 1930s. The US economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while FDR tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3 percent in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again. […]

To sum up: A few months ago the US economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss.

Although we’re are on the other side of the economic divide from Krugman (we don’t believe the government can borrow and spend its way out of a debt crisis), he makes an interesting point about the difficulty of reversing course once the government puts an entire economy on fiscal and monetary life support.

Now that the feds have become such large players in the economy (backstopping over 80% of GDP and pouring trillions of dollars of liquidity into the system), the next challenge is for them to exit the market without causing another severe leg-down.

Considering the government mucks up everything it gets its fingers on, this “grand exit” should be no different. The feds will either pull liquidity out too fast, pushing the economy into protracted slowdown, or they will fail to reabsorb liquidity fast enough, triggering a great inflation. Here at Notes, our hunch is it will be the latter…