After 2008, the Southern European economies suffered a strong and persistent increase in unemployment. Rising government bond spreads necessitated the implementation of austerity policies. Austerity, however, may increase unemployment. If workers lose human capital during unemployment spells, the economy’s future production potential and thus the fiscal capacities to serve public debt will decline, aggravating a sovereign debt crisis. Haircuts can help to avoid the costs of austerity. I introduce skill loss during unemployment in a dynamic stochastic model of sovereign debt with long-term debt and labor market frictions to study optimal fiscal policy in sovereign debt crises. In a quantitative exercise, I find that with higher intensity of the skill loss, ex ante, fiscal policy becomes less pro-cyclical and unemployment less volatile. During crises, early haircuts are associated with the largest short-term welfare gains and the strongest short-run and medium-run unemployment reductions.