Fixing the Euro Crisis: Policy Recommendations

by: Carnegie Endowment

Greece, Ireland, Italy, Portugal, and Spain

  • Implement fiscal consolidation to stabilize the debt-to-GDP ratio within three years.
  • Structural reforms designed to rebalance the economy toward the tradable sectors and increase competitiveness are essential. To facilitate this, reduce unit labor costs by at least 6 percent over three years—either immediately with a 6 percent across-the-board wage cut, or more gradually—and institute structural reforms to raise productivity. Begin with public sector wages.
  • Explain the severity of the situation to citizens in order to build the public will necessary for these adjustments. Distribute the adjustments in a transparent and fair way to ensure that specific groups do not feel unjustly hit, and that the most vulnerable are protected.


  • Seriously consider restructuring the debt, allowing time for creditors to prepare to facilitate progress on an agreed solution.
  • Prepare for a severe contraction in employment and income—likely larger than forecasts predict—regardless of how the crisis is resolved.
  • Rely increasingly on exports and undertake measures, including encouraging wage reduction in the private as well as the public sector, to restore competitiveness, in spite of political challenges.
  • If progress on restoring competitiveness is not achieved within a reasonable time frame, consider leaving the Euro area—this will imply restructuring the debt.


  • Maintain reforms to lower the deficit, including expanding the tax base, increasing the minimum pension age, reducing social welfare benefits, and cutting public wages.
  • Promote further rebalancing of the economy away from services and the financial sector toward exports.
  • Encourage flexible management of financial sector support programs as they respond to continuing trouble. When appropriate, unwind the guarantees.


  • Reduce the primary deficit by 4 percent of GDP over three years.
  • Attack rigidities that create a dual labor market.
  • Increase the efficiency of backbone services.


  • Increase flexibility in labor markets.
  • Increase competition in relatively sheltered backbone services.
  • Improve the human capital base. This will improve productivity and help the country regain attractiveness with foreign investors.
  • Implement a systematic approach to correct deficiencies in the business climate, especially in starting a business, paying taxes, and getting credit.


  • Reduce the primary deficit by 8 percent of GDP within three years.
  • Increase competition and decrease barriers to entry to help lower the price of non-tradables.
  • Lower the severance costs that employers must pay to terminated employees that create labor market inflexibility.

Euro Area

  • Maintain an expansionary monetary policy that errs on the side of growth for an extended period.
  • Explicitly promote a weak euro.
  • Require countries to cede some fiscal autonomy. Give member states the right to review other members’ annual budgets and main economic indicators, such as GDP growth, productivity growth, and the balance of payments.
  • Allow European governments—not just the European Commission and the IMF—to discuss, propose, and monitor action taken by the GIIPS, as well as agree on appropriate sanctions.
  • Tighten the criteria for admission to the Euro area. Require newcomers to run large fiscal surpluses to offset the demand boom that typically accompanies euro adoption. Do not require one size to fit all, however; consider cyclical as well as structural indicators.
  • Implement requirements that existing members and members-to-be release timely, reliable, and comparable data on macroeconomic indicators.

Germany and Other Surplus Countries

  • Expand domestic demand by about 1 percent of the Euro area’s GDP over three years in order to offset the deflationary impact of fiscal adjustments in the GIIPS.
  • Accept slightly higher inflation to keep the aggregate European rate in the 2 percent range.

Prospective Euro Area Members

  • Do not rush to join the Euro area before addressing competitiveness problems at home and making sure that inflation and interest rate convergence is almost total before accession.
  • Increase taxes on non-tradables (e.g., housing) relative to tradables.
  • Save the windfall revenues likely to come during the euro boom to cushion fiscal adjustment once growth slows.
  • Use the boom as an opportunity to move into higher value-added and faster-growth sectors, and toward a more outward-oriented production structure.

The Rest of the World

  • Rely more on domestic demand.
  • Look to the global lender of last resort, in the form of the IMF, when significant resources, broader expertise, and distance from regional politics are needed.
  • If support packages are needed, ensure that they are of sufficient size to reassure markets.

Developed Countries

  • Maintain stimulus efforts in the short term. Strong economic growth is the best long term debt reduction strategy and the global recovery is still dependent on government support.
  • Restrain spending and/or increase taxes as soon as a robust recovery is established.

United States

  • Accept a lower euro.
  • Expand the resources available to the IMF.
  • Expand the Fed’s currency swap operations.
  • Use moral suasion to push for necessary adjustments within Europe.

Developing Countries

  • Rely less on exports to the industrial countries and more on South-South trade.
  • Match the currencies of foreign liabilities with those of export proceeds and reserve holdings.
  • Moderate the inflow of portfolio capital and encourage the more stable form of foreign direct investment instead.
  • Allow the currency to appreciate if the external surplus is large and capital inflows are significant.
  • Closely monitor and tightly regulate the operation of foreign banks and their links with domestic banks.
  • Either allow the exchange rate to float, or institute tight capital controls if the exchange rate is pegged.