Macroeconomic Impact of the Budget Deal: Very Quick Estimate

In the e-mail age, there aren't as many envelopes lying around to do calculations on the back of, but I've nonetheless managed to do some rough figurin':

Last night's deal on the budget cuts $37.8 billion in spending.  I haven't seen the exact composition yet, but most of it is presumably "domestic discretionary spending" - i.e., the stuff that counts as government purchases in the national income accounts.

Generally we do our macroeconomic calculations at 'annual rates', and since there is about six months left in the fiscal year covered by the budget (i.e., the government budgets start in October), the cut is $75.6 billion at an annual rate.  The most recent GDP estimate is an annual rate of $14,871 billion for the fourth quarter of 2010, so lets call it $15,350 billion for the second third quarters of 2011 (based on roughly 5% nominal GDP growth, consistent with FOMC members' forecasts); that implies the cuts are 0.5% of GDP at an annual rate.

If we put the multiplier at 1.75, which is the midpoint of the CBO's range of estimates, the cuts reduce GDP by 0.875% at an annual rate.  The rule of thumb known as Okun's law says that, for every percentage point less of GDP growth, the unemployment rate increases half a percentage point.  So, over the course of a year, that would put unemployment at 0.4375 higher.  Since this is over six months, we're talking about an 0.22 point increase in the unemployment rate.  On a labor force of 153.4 million, that translates to a loss of 337,500 jobs.

Like Ezra Klein says, 2011 is not 1995:

Right now, the economy is weak. Giving into austerity will weaken it further, or at least delay recovery for longer. And if Obama does not get a recovery, then he will not be a successful president, no matter how hard he works to claim Boehner’s successes as his own. Clinton’s speeches were persuasive because the labor market did a lot of his talking for him. But when unemployment is stuck at eight percent, there’s no such thing as a great communicator.

Notes:
A more conservative multiplier estimate of 1 implies a job loss of about 191,750.

The macroeconomic argument for a positive effect from such a deal would rely on the idea that deficit reduction improves confidence in the future.  In particular, if the government's future borrowing needs are reduced, there would be less "crowding out" of investment, and if future taxes are reduced, then lifetime disposable income has increased, which would generate higher consumption today.  I don't think either of those are relevant to a short-term budget deal when there is significant slack in the economy.  However, since many Americans seem to erroneously believe that government spending is hurting the economy, perhaps they will also think this is good for it.  Confidence, even for the wrong reasons, matters...

Not much has been said about the composition of the cuts, but I suspect they will be uglier than people realize.  While $38 billion sounds small relative to some of the numbers that get thrown around in budget discussions, it is quite significant relative to "nondefense discretionary spending" - i.e., what people usually think of as "the federal government" (see this previous post).

Update (4/14): Maybe not so bad.  It appears that the actual cuts are significantly smaller - apparently a significant portion of the $38.5 billion in "budget authority" being cut is money that probably wouldn't have been spent this year anyway.

The ECB Tightens

The European Central Bank just announced an increase its policy interest rate from 1% to 1.25%.  Their decision highlights some current monetary policy dilemmas.

Core versus overall measures of inflation.  As ECB President Jean-Claude Trichet explained:

Euro area annual HICP inflation was 2.6% in March 2011, according to Eurostat’s flash estimate, after 2.4 % in February. The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not lead to second-round effects in price and wage-setting behaviour and thereby give rise to broad-based inflationary pressures over the medium term. Inflation expectations must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term. 

That is, the recent blip in inflation is largely due to energy prices, but the worry is that this will lead to higher wage demands and ultimately more general price increases.  This would be particularly bad if people began to make plans based on expectations of higher inflation (i.e., expectations became un-"anchored").  Those worries are ill-founded, says Paul Krugman:

Overall eurozone numbers look very much like US numbers: a blip in headline inflation due to commodity prices, but low core inflation, and no sign of a wage-price spiral. So the same arguments for continuing easy money at the Fed apply to the ECB. And the ECB is not making sense: it’s raising rates even as its official acknowledge that the rise in headline inflation is likely to be temporary.

Former Fed governor Larry Meyer had a nice op-ed on the subject in the Times last month.

Inflation targeting and "credibility." A temporary energy-price driven inflation spike may be harder for an inflation-targeting central bank like ECB to brush off.  The goal of inflation targeting is to make monetary policy credible - i.e., to keep inflation expectations anchored - but it only works if the announced target is met.  Gavyn Davies writes:

Of course, when an adverse supply shock hits the economy, there are no easy paths for the central bank to adopt, and the ECB will protest that its mandate requires it to hit its CPI inflation target regardless of the consequences for GDP growth. But it can expect no praise if it pushes the economy back into recession.

The optimum currency area problem.  Or, really, the problem that the euro zone isn't one.  The single currency means a single monetary policy.  That works if the economies of Europe move together, but they aren't.  This map of unemployment rates across Europe illustrates the problem:

The lightest yellow shade are countries with unemployment rates below 7% and the darkest red have rates above 13%, including 14.9% in Ireland and 20.5% in Spain.  (A small irony: Eurostat's nifty map tool makes it very easy to illustrate the fundamental flaw of the euro project).  In the high unemployment countries, it is hard to imagine that workers would be in a strong position to demand higher wages to make up for the increase in energy prices.  But Trichet's worry may make more sense in the parts of Europe where labor markets are tighter.  And Trichet can only make one monetary policy.  As Floyd Norris puts it:

“If you take the euro area as a whole . . .”
So began a response Thursday from Jean-Claude Trichet, the president of the European Central Bank, as he explained the central bank’s decision to raise interest rates in Europe.
If only there were a “euro area as a whole.”

This is exacerbated by the fact that several of the smaller eurozone countries are also undergoing sovereign debt crises.  David Beckworth has the appropriate musical reference - it may be the final countdown for Europe:

[T]his move may have begun the countdown to the Eurozone breakup.  It is hard to see how else this can turn out.  The Germans--the folks who really call the shots in Europe--are reluctant to see the needed debt restructuring in the periphery and are equally reluctant to provide bailouts large enough to fix the problem. So far the Germans have been kicking the can down the road on these issues. With ECB monetary policy now tightening they will soon run out of road to kick the can down. 

One irony here is that many of the same sorts of people who have taken to criticizing the Fed for "printing money" are also prone fretting that America is sliding down the slippery slope to "European socialism" (trains and universal healthcare - quelle horreur!).  Next time Ron Paul says we need to return to "sound money", someone needs to tell him to move to Europe!

March Employment: Sluggish Acceleration Continues

If the US economy was a car, Motor Trend would not be impressed with its acceleration...

The BLS reports that nonfarm payrolls (i.e., "jobs") increased by 216,000 and the unemployment rate decreased to 8.8% in March (from 8.9% in February).

That's the best payroll number since last spring - the economy appeared to be entering a more rapid recovery with 277,000 and 458,000 jobs added in April and May 2010, respectively, before it wobbled last summer.  Overall, the March numbers are consistent with an economy climbing out of a deep hole (13.5 million people remain unemployed) at a painfully slow pace. 

The slow employment recovery is consistent with the pattern established by the two recessions of the "great moderation" era, in 1990-91 and 2001, but those recessions were quite mild by comparison.  This is a disappointment to those of us who were hoping that the a severe recession would be followed by a sharp recovery, like in the last downturn of comparable magnitude, in 1981-82.

The payroll number comes from a survey of firms, and the unemployment rate is calculated from a survey of households.  The household survey reported an increase of 291,000 in the number of people employed; the number of unemployed decreased by 131,000 and the labor force increased by 160,000.  Labor force participation was steady at 64.2%.   

On a non-seasonally adjusted basis, the unemployment rate fell from 9.5% to 9.2%, and payroll employment rose by 925,000.  That is, the economy actually added alot of jobs in March, but a large part of that is a normal seasonal increase, so we shouldn't get excited about it.

See also: Calculated Risk, Ezra Klein, Sudeep Reddy.

The Spaghetti Bowl is Not Deep

At Vox, Theresa Carpenter and Andreas Lendle ask, "How Preferential is World Trade?"  Their answer:

We find that around half of world imports are from countries that are granted some preference – yet that does not mean that all of that trade is actually preferential. MFN rates may be zero or a product can be excluded from preferences. Overall – but not including intra-EU trade – just 16.3% of global trade has a positive preferential margin. Preferential margins are distributed as follows:

• 10.5% of total trade has a margin of 5 percentage points or less, 3.9% has a margin of 5-10 percentage points, 1.3% has a margin of 10-20 percentage points and only 0.5% has a margin of 20 percentage points and above.
• Around 30% of global trade is not eligible for preferences and subject to non-zero MFN rates, although almost 2/3 of that trade faces tariffs of 5% or less.
• More than half (52%) of world trade is at MFN zero, so no preferences can be granted. 

By "preferential margin," they mean the gap between the "most favored nation" tariff, which all WTO members are expected to apply to imports from other members, and the lower tariffs which might apply under regional and bilateral trade agreements.  For example, if the US has a 10% MFN tariff on cogs, but under NAFTA, cogs from Mexico enter the US tariff-free, that would mean a 10% preferential margin.

This addresses one of the main complaints about trade agreements: that they lead to preferences.  This can lead to "trade diversion," whereby a country imports a good from someplace that isn't the most efficient producer - in the above example, if Brazilian cogs were 5% less costly than Mexican cogs, without NAFTA, the US would import them from Brazil; NAFTA causes the US to shift to Mexican cogs (and lose the tariff revenue).  As a political economy matter, this might also mean that Mexico is less likely to support multilateral liberalization - e.g., a reduction in cog duties in the WTO Doha round talks - because it enjoys its privileged access to the US market.  That is, preferential agreements lead to worries about "preference erosion" which could hinder broader tariff reductions.

These are two aspects of the general criticism that regional trade agreements create what is known as the "spaghetti bowl phenomenon" described thus in an academic article by Jagdish Bhagwati, David Greenaway and Arvind Panagariya:

The result [of the proliferation of regional trade agreements] is…the ‘spaghetti bowl’ phenomenon of numerous and crisscrossing PTAs and innumerable applicable tariff rates depending on arbitrarily-determined and often a multiplicity of sources of origin. In short, the systemic effect is to generate a world of preferences, with all its well-known consequences, which increases transaction costs and facilitates protectionism. In the guise of freeing trade, PTAs have managed to recreate the preferences-ridden world of the 1930s as surely as protectionism did at the time. Irony, indeed!

One of the interesting questions in trade is whether "free trade" agreements really deserve the name.  Carpenter and Lendle's evidence suggests that perhaps some of the criticisms - while valid in theory - may be overdone in practice.

Glasnost!

Ben Bernanke will be meeting the press, the Fed announced:

Chairman Ben S. Bernanke will hold press briefings four times per year to present the Federal Open Market Committee's current economic projections and to provide additional context for the FOMC's policy decisions.

In 2011, the Chairman's press briefings will be held at 2:15 p.m. following FOMC decisions scheduled on April 27, June 22 and November 2. The briefings will be broadcast live on the Federal Reserve's website. For these meetings, the FOMC statement is expected to be released at around 12:30 p.m., one hour and forty-five minutes earlier than for other FOMC meetings.

The introduction of regular press briefings is intended to further enhance the clarity and timeliness of the Federal Reserve's monetary policy communication. The Federal Reserve will continue to review its communications practices in the interest of ensuring accountability and increasing public understanding. 

Wow.  It wasn't too long ago that I remember watching one of Bank of England Governor Mervyn King's press conferences and thinking "that will never happen here."

This is another step that follows from a significant evolution in what is seen as good practice by central banks.  The Fed and other central banks once believed in the importance of using secrecy to cultivate a mystique.  It was not for nothing that William Grieder titled his 1987 classic about the Fed "Secrets of the Temple."  The Fed only began announcing changes in its policy stance in 1994, announcements of explicit Fed Funds rate targets followed in 1995.

This trend towards openness partly reflects the influence of academic views, as modern macroeconomic models assign important roles to expectations, information and credibility (which can be cultivated by making policy announcements and then sticking to them).  Its not surprising to see Bernanke pushing in this direction, given his background as a prominent academic economist (in contrast to his predecessor).  The previous procedural step in this direction was in November 2007, when Bernanke instituted the practice of having the FOMC members release their forecasts.  Bernanke also appeared on 60 minutes last December, which would have been unthinkable to the previous generation of central bankers.

Update: Real Time Economics has reaction from some Fed watchers and a chronology of the Fed's increasing openness.

DeLong on Friedman

Although it was once considered the big divide in macroeconomics, contemporary "Keynesianism" and "Monetarism" may not be so far apart (some would argue that's because modern "New Keynesians" aren't really Keynesians at all, but I digress...).  These days, they are mostly on the same side in arguing that policy can do something (other than damage) to smooth economic fluctuations and, by extension, persistent high unemployment is a policy failure.

This reveals a contradiction between how Milton Friedman is perceived and what his ideas really meant, Brad DeLong explains:

In the 1950s and 1960s and 1970s Milton Friedman faced a rhetorical problem. He was a laissez-faire libertarian. But he also believed that macroeconomic stabilization required that the central bank be always in the market, buying and selling government bonds in order to match the supply of liquid cash money to the demand, and so make Say's Law true in practice even though it was false in theory.

Such a policy of constant government intervention to continually rebalance aggregate demand is hardly a laissez-faire hands-off libertarian policy, is it?

Friedman, however, set about trying to maximize the rhetorical distance between his position--which was merely the "neutral," passive policy of maintaining the money stock growth rate at a constant--and the position of other macroeconomists, which was an "activist," interventionist policy of having the government disturb the natural workings of the free market. Something went wrong, Friedman claimed, only when a government stepped away from the "neutral" monetary policy of the constant growth rate rule and did something else.

It was, I think, that description of optimal monetary policy--not "the central bank has to be constantly intervening in order to offset shocks to cash demand by households and businesses, shocks to desired reserves on the part of banks, and shocks to the financial depth of the banking system" but "the central bank needs to keep its nose out of the economy, sit on its hands, and do nothing but maintain a constant growth rate for the money stock"--that set the stage for what was to follow in Chicago.

First, Friedman's rhetorical doctrine eliminated the cognitive dissonance between normal laissez-faire policies and optimal macro policy: both were "neutral" in the sense of the government "not interfering" with the natural equilibrium of the market. Second, Friedman's rhetorical doctrine eliminated all interesting macroeconomic questions: if the government followed the proper "neutral" policy, then there could be no macroeconomic problems. Third, generations of Chicago that had been weaned on this diet turned out to know nothing about macro and monetary issues when they became important again.

It is in this sense, I think, that I blame Milton Friedman: he sold the Chicago School an interventionist, technocratic, managerial optimal monetary policy under the pretense that it was something--laissez-faire--that it was not.

February Employment: Slightly Better

According to today's report from the BLS, the unemployment rate ticked down to 8.9% (from 9.0%) in February, and payrolls increased by 192,000.

Those are both solid improvements, though I had been hoping for better in light of other very positive recent data like the ISM index.

The labor force participation rate was unchanged at 64.2, so at least the decline in the unemployment rate was not driven by people leaving the labor force (to be counted as unemployed, a person must report that they are looking for work).  That is in contrast to the big decline in the unemployment rate in December and January, where declining participation was a major factor.

If the recovery gets stronger, the participation rate should be expected to start rising.

The unemployment rate and labor force participation rate are calculated from a survey of households, which reported an increase of 250,000 in the number of people employed (the payroll number cited above comes from the survey of businesses, which has a larger sample).  February is one of the months where the seasonal adjustment to the unemployment rate is downwards; on a non-seasonally adjusted basis, the unemployment rate was 9.5% (down from 9.8% in January).

The BLS also revised upward the payroll employment increase estimates for December, to 152,000 (from 121,000) and January, to 63,000 (from 36,000).  It may be that some of the February increase really occurred in January, but wasn't properly counted due to the weather in January - a rough way to correct for this is to look at the average of the two months, which is an unimpressive 127,500 (that's roughly the pace needed to keep the unemployment rate stable as the population grows).

Worth noting amid the sturm-und-drang over state budget cuts:

Employment in both state and local government edged down over the month. Local government has lost 377,000 jobs since its peak in September 2008.

U-6, the BLS' broadest measure of unemployment and underemployment, which includes people who are "marginally attached" to the labor force and those who are working part-time but want to work full-time stands at 15.9% (seasonally adjusted), down from 16.1% in January.

Update: More reactions/analysis from Mark Thoma, Paul Krugman, David Leonhardt, Floyd Norris, Calculated Risk, Free Exchange, Gavyn Davies and RTE's round up of Wall Street commentary.

Scientists vs Engineers?

The House Republicans' plan to cut federal spending by $61 billion for the remainder of the fiscal year (i.e., the period between now and the end of October) will be a drag on the economy and reduce employment, according to both Goldman Sachs and Moody's Mark Zandi, who says:

The House Republicans’ proposal would reduce 2011 real GDP growth by 0.5% and 2012 growth by 0.2 percentage points This would mean some 400,000 fewer jobs created by the end of 2011 and 700,000 fewer jobs by the end of 2012.

This shouldn't come to a surprise to macroeconomics students, who know that a decrease in government purchases reduces aggregate demand and - outside of the special "classical" case of vertical aggregate supply - output.

John Taylor disagrees, however.  Ezra Klein explains:

Mark Zandi says the GOP's proposed spending cuts will cost about 700,000 jobs. John Taylor says they will "increase economic growth and employment." Both are respected economists who immerse themselves in data, research and theory. So how can they disagree so sharply?

The dispute comes down to how much weight you give to "expectations" about future deficits. Taylor's argument is that Zandi's model -- which you can read more about here -- doesn't account for the upside of deficit reduction -- namely, that when the government spends less, the private sector will spend more. Taylor thinks individuals and businesses are hoarding their money because they're afraid of the high taxes, sharp spending cuts and assorted other nastiness that deficit reduction will eventually require. "The high unemployment we are experiencing now is due to low private investment rather than low government spending," he writes. "By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment."

A similar disagreement is playing out over monetary policy.  In a recent NY Times column, Christina Romer wrote:

The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

Though there is much debate about what level of unemployment is now normal, virtually no one doubts that at 9 percent, unemployment is well above it. With core inflation running at less than 1 percent, empiricists are therefore relatively unconcerned about inflation in the current environment.

Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. In these models, Fed actions that call its commitment to low inflation into question can cause inflation expectations to spike, leading to actual increases in prices and wages. 

She sides with the "empiricists" and argues that the influence of the "theorists" has held the Fed back from taking bolder, more effective action.  Stephen Williamson begs to differ:

Romer says some things about economic history in her piece, but of course she is very selective, and seems to want to ignore the period in US economic history and in macroeconomic thought that runs from about 1968 to 1985. Let's review that. (i) Samuelson/Solow and others think that the Phillips curve is a structural relationship - a stable relationship between unemployment and inflation that represents a policy choice for the Fed. (ii) Friedman (in words) says that this is not so. There is no long-run tradeoff between unemployment and inflation. It is possible to have high inflation and high unemployment. (iii) Macroeconomic events play out in a way consistent with what Friedman stated. We have high inflation and high unemployment. (iv) Lucas writes down a theory that makes rigorous what Friedman said. There are parts of the theory that we don't like so much now, but Lucas's work sets off a methodological revolution that changes how we do macroeconomics. 

The divides between Goldman/Zandi and Taylor over fiscal policy and between Romer and Williamson over monetary policy both reminded me of Greg Mankiw's distinction between "scientific" and "engineering" macroeconomics. The models used by the "engineers" - the people in Washington and on Wall Street who need to make practical, quantitative assessments of the impact of policy alternatives on the economy - are more elaborate versions of the "textbook" Keynesian IS-LM aggregate supply and demand framework that most of us (still) teach our macroeconomics students.  As Williamson points out, the models used by academics - Mankiw's "scientists" - in our research are fundamentally different.

The engineering models are built on relationships among aggregate macroeconomic variables like the Phillips curve, which relates inflation and unemployment, and the consumption function, which connects consumption and disposable income.  As Williamson alludes to, Robert Lucas and others won a methodological war in the profession (or at least the academic branch of it) in the 1970s and 1980s.  The result of their victory is that the macroeconomic models published in leading journals today are expected to be grounded in the optimizing, forward-looking behavior of rational individuals.

Such individuals might believe, for example, a reduction in government spending today implies that their future taxes will be lower (because the government will be servicing a smaller debt burden).  The resulting increase in their lifetime disposable income means that they will immediately increase their consumption.  So any negative impact of a cut in government purchases is offset by an increase in consumption.  Rational, forward-looking optimizers might also recognize that any monetary expansion will erode their real wages and demand an offsetting increase in nominal wages.  This means that employment will remain unchanged (because the real cost to the firms of a worker is the same) even as inflation rises.

At its most extreme, the assumption of dynamic optimization under rational expectations was once believed to imply the Lucas-Sargent "Policy Ineffectiveness" proposition, which Bennett McCallum explained in a 1980 Challenge article:

Macroeconomic policies - sustained patterns of action or reaction - will have no influence because they are perceived and taken into account by private decision-making agents. Thus, the adoption of a policy to maintain "full employment" will not, according to the present argument, result in values of the unemployment rate that are smaller (or less variable) on average than those that would be experienced in the absence of such a policy.

Of course, in a world of rationally optimizing people, where prices adjust to clear markets, it is hard to explain how we could get to such large deviations from the natural rate of unemployment in the first place...

More generally, while macroeconomic science has continued on the methodological path established by Lucas, many of its practitioners have worked to re-incorporate real effects of monetary policy.  This is a large part of the "New Keynesian" project, which is arguably now the reigning paradigm and best hope for reuniting "science" and "engineering" (and arguably is as much "monetarist" as it is "Keynesian").

Fiscal policy has received less attention - the implausibility of managing aggregate demand through the slow, cumbersome and messy budget process means that, in general, the focus has been on the Fed.

That has started to change as the global slump has pushed conventional monetary policy to its limits (and beyond into unknown worlds of unconventional policy), and governments around the world have made fitful attempts at fiscal policy.  For example, recent papers by Christiano, Eichenbaum and Rebelo, Gauti Eggertson and Michael Woodford have shown that it is possible for fiscal policy to have significant multiplier effects when monetary policy is at the zero lower bound (as it is today) in New Keynesian models.

So, while, at a superficial level, it appears that the split between "scientists" and "engineers" persists, some of the "scientific" work being done today is finding that the remedies proposed by the "engineers" are not wholly inconsistent with forward-looking rational behavior after all.

Econ Journal Footnote of the Year

Foletti, L., Fugazza, M., Nicita, A. and Olarreaga, M. (2011), Smoke in the (Tariff) Water. The World Economy, 34: 248–264

9 The song ‘Smoke on the Water’ was written by Deep Purple and refers to the fire that took place at the Montreux Casino during Frank Zappa’s concert in the 1971 Festival. Montreux is at the opposite end of Lake Geneva from the WTO.

As the article explains, the gap between the tariff limits countries have agreed to under the WTO - "tariff bindings" - and the tariffs they actually impose is known as the "tariff water."  This means that, in practice, countries could raise many tariffs without violating their WTO commitments.  After accounting for tariff bindings that are above prohibitive levels and the constraints of regional trade agreements, the paper looks whether countries have used their available "policy space" to increase protection during the global recession (and finds that, generally, they haven't very much).

Or, one might say they decided not to go (Policy) Space Truckin'.

For a follow-up, might I suggest: Woman from (the) Tokyo (Round) ?

If you think you're not familiar with "Smoke on the Water," after the first 20 or so seconds of this you will realize that you are (its the holy trinity of rock).  Also: Space Truckin' and Woman from Tokyo.

Central Bank Independence

Ben Bernanke's British counterpart, Mervyn King, is taking alot of heat for supporting the government's harsh package of spending cuts and tax increases.  Paul Krugman writes:

Mervyn King, governor of the Bank of England, has stepped way over the line by turning into a cheerleader for the current government’s policies. He’s wrong on the economics — front-loaded spending cuts are the wrong policy for a still-depressed economy — but that’s not the key point; rather, the point is that if you’re going to have an independent central bank, the people running that bank have to be careful to stay above the political fray.

A Guardian story quotes Ed Balls, the Labour party shadow chancellor (i.e., the opposition's point person on economic policy):

"The last thing you ever want is for the Bank of England to be drawn into the political arena," said Balls, who was involved in Labour's move in 1997 to give the Bank independence to set interest rates. "Central bank governors have to be very careful about tying themselves too closely to fiscal strategies, especially when they are extreme and are making their job on monetary policy more complicated."

One of the things that comes with central bank independence is the expectation that central bankers should be neutral technocrats who keep a narrow focus on monetary policy.  In part, this is because central bank independence is a fragile thing, which could be undone by a change to the Federal Reserve Act in the US, or, in the UK, the Bank of England Act.  While respect for the principle of central bank independence - exemplified by the fact that Greenspan and Bernanke, both Republicans, were re-nominated by Democratic presidents - has evolved over time, it could be eroded if the central bank was seen to be a partisan actor.

However, I have a bit more sympathy for Governor King than Krugman and Balls do.  Central bankers face a dilemma because, while they are rightly expected to stay out of "politics" generally, fiscal policy and monetary policy are interdependent.  The central bank is responsible for one part of a fiscal and monetary "policy mix," and its decisions depend on (and are constrained by) the government's tax and spending decisions, and vice-versa. 

In the UK, the Bank of England is accommodating "tight" fiscal policy with "loose" monetary policy.  To a slightly less dramatic degree, this also occurred between the Clinton administration and the Greenspan Fed in the early 1990's.  The early 1980's saw the opposite mix in the US: simultaneously tight monetary policy and loose fiscal policy.  While the monetary tightening was seen as necessary to bring inflation under control, it probably wouldn't have had to have been so severe if the Reagan administration's tax cuts and spending increases weren't occuring at the same time.

Since the ultimate impact of a fiscal policy depends on how monetary policy will react, the political system, in theory, could make better-informed decisions if the central bank communicated its views and intentions.  Moreover, because monetary policy has to react to fiscal policy, it is arguably legitimate for the central bank to have preferences about it.

The argument Krugman and Balls are making implies that the benefits from a more explicit coordination of monetary and fiscal policy, which requires central banks to speak about fiscal policy, is outweighed by the damage to central bank independence that occurs when central bankers like King express themselves on "political" tax and spending matters.