The euro area sovereign debt crisis highlighted important weaknesses in the euro area design. Fiscal policy did not build sufficient buffers before the crisis, which forced some countries to tighten fiscal policy too rapidly during the downturn to restore market confidence in sovereign borrowing. Despite this, sovereign stress remained high, weakening further the banking sectors highly exposed to government bonds, which in return reduced further market confidence in fiscal sustainability in case of banks’ bailout. As a result, monetary policy was the main public instrument to support the activity, but its effectiveness was reduced by the fragmentation of financial markets along national lines as the crisis deepened. In order to durably sever the links between banks and their sovereigns, euro area countries agreed on a banking union. The creation of a common supervisor was a very important step in that direction. However, further progress is needed in reducing and sharing risks, creating a common deposit guarantee scheme and the application of existing rules to ensure sufficient risk sharing can take place in case of crisis. At the same time, incentives need to be put in place for banks to progressively move away from a too high exposure to domestic sovereign bonds. A step in that direction could be the introduction of euro area safe asset, which would pool sovereign issuance from various countries, in parallel with gradual introduction of capital surcharges on sovereign exposures. Such progress may not be sufficient, however, for national fiscal policies and monetary policy to smooth a major crisis. The introduction of common fiscal stabilisation capacity is necessary to buttress the euro area in case of a deep recession, both at the country level and euro area level. Finally, policies aiming at further cross-border integration of capital markets should reinforce private risk sharing, reducing the burden on macro policies.

This Working Paper relates to the 2018 OECD Economic Survey of the Euro Area.

(http://www.oecd.org/eco/surveys/economic-survey-european-union-and-euro-area.htm)