The Eurozone crisis has demonstrated how an insolvent sovereign can destroy a national banking system, Greece, but also how an insolvent banking system can almost sink the sovereign – Ireland and Spain (Wyplosz 2012).
Localised real estate boom and bust
Local real estate booms and busts are a recurring phenomenon. The US has had its fair share, and its experience provides a useful lesson for Europe. Real booms of the last decade were very localised on both sides of the Atlantic. In the Eurozone, the overbuilding of houses on a large scale really only occurred in Spain and Ireland. Similarly, in the US, a handful of states accounted for a very large share of the subsequent losses on mortgage lending. One of these states, Nevada, is rather similar in size to Ireland.
A natural experiment
Thus, we have, by coincidence, something close to a natural experiment; two similar regions which both experience a local real estate boom and bust, but within a very different federal system.
Ireland and Nevada are rather similar in several important respects (cf. Table 1). They have similar populations (2.7 to 4.5 million) and similar levels of GDP ($120-200 billion). Most importantly, they both experienced an exceptionally strong housing boom and bust. The result of the same boom-bust cycle for the real economy can be seen in the unemployment rate, which followed an almost identical pattern, as shown in Figure 1.
Table 1. Ireland and Nevada compared
Sources: Eurostat and BEA, US Census Bureau.
No bail out in Nevada
However, there is one fundamental difference between the two. When the boom turned to bust, Nevada did not experience any local financial crisis and the state government did not have to be bailed out. This might the key reason behind the large difference in the evolution of GDP, which fell much more in Ireland.
The key difference between Nevada and Ireland is that banking problems in the US are taken care of at the federal level – remember, the US is a banking union – whereas in the Eurozone, responsibility for banking losses remains national.
Local banks in Nevada experienced huge losses, just like in Ireland, and many of them became insolvent, but this did not lead to any disruption of the local banking system as these banks were seized by the Federal Deposit Insurance Corporation (FDIC), which covered the losses and transferred the operations to other, stronger banks. In 2008-09, the FDIC thus closed 11 banks headquartered in the state, with assets of over $40 billion, or about 30% of state GDP. The losses for the FDIC in these rescue/restructuring operations amounted to about $4 billion.
Figure 1. The boom/bust cycle in unemployment: Ireland vs Nevada
Sources: Eurostat and US Bureau of Labour Statistics (BLS).
Other losses were borne at the federal level when residents of Nevada defaulted in large numbers on their home mortgages. The two federal institutions that re-finance mortgages have lost between them about $8 billion in the state since 2008.
The federal institutions of the US banking union thus provided Nevada with a ‘shock absorber’ of about 10% of GDP, not in the form of loans, but in the form of an ex-post transfer. That is, losses of this magnitude were borne at the federal level. Against this transfer one would of course have to set the insurance premiums paid by banks in Nevada prior to the bust. But they are likely to have been an order of magnitude smaller.
The significance of ‘foreign banks’ in Nevada
Moreover, a lot of the banking business in Nevada was (and still is) conducted by ‘foreig