As the note by Holland and Portes linked to earlier by Stephen is likely to be influential in the fiscal policy debate, it is worth taking a closer look at the findings with the Irish case in mind. The note is based on a more detailed (and very useful) analysis by Dawn Holland (available here).
Although the main message on the impact of (coordinated) fiscal adjustment is quite negative, the fact that Ireland is the only country for which the adjustment leads to a (small) fall in the debt to GDP ratio might appear to give some comfort. But I don’t think we can take comfort on the score. Not surprisingly, the reason Ireland stands out as an outlier in this analysis is because of relatively small (normal-case) multipliers. (The multipliers are assumed to be higher in the context of the current crisis, but the precise “crisis multipliers” used for Ireland are not given in the paper.) The assumed normal-case multiplier is -0.36 for a decrease in government consumption and -0.08 for an increase in income taxes. I would guess that the relatively low assumed normal-case multipliers for Ireland reflect Ireland’s high imports as a fraction of GDP. But as discussed here, a large fraction of imports in Ireland are used as inputs into the production of exports. As a result, the high import share can give a misleading view of the marginal propensity to import out of domestic demand. Controlling for exports, a simple regression shows that a one euro increase in domestic demand is estimated to raise imports by 0.23 euro, indicating substantially less leakage from expansions in domestic demand than the crude import share would suggest.
While I don’t think we can get any comfort from Ireland being an outlier in the analysis, I do have concerns about the broad conclusion of the paper. This conclusion is that fiscal adjustment has actually raised debt to GDP ratios. To the extent that the debt to GDP ratio is critical for creditworthiness, this suggests that efforts have been self-defeating on this central measure.
