The Effect of Falling House Prices in UK

What happens if there is a fall in House Prices in the UK?

If house prices fall, what will happen to the economy and homeowners? Are falling house prices always a bad thing?

1. Effect on Wealth.

The first effect of falling house prices is to directly reduce the wealth of homeowners (wealth is of course different to income). Housing is by far the biggest form of wealth in the UK. Therefore, a fall in house prices will definitely reduce consumer confidence. This will lead to lower levels of spending; people will be more reluctant to undertake risky investments and borrowing.

2. Effect on Equity Withdrawal.

Rising house prices enable equity withdrawal. This means that homeowners can remortgage their house to consolidate unsecured loans and / or gain more money to spend. In recent years, this equity withdrawal has played a significant role in boosting consumer spending in the UK. Falling house prices would bring to a halt equity withdrawal; therefore, consumer spending will increase at a slower rate or even fall.

3. Housing is a significant Barometer of the state of the Economy.

More than any other country, in the UK, house prices and the housing market are seen as a barometer to the state of the economy. Any fall in house prices is likely to receive significant press coverage. (even tenuous predictions of falling house prices have been frequently making the front page of newspapers like the Daily Mail and Express) This magnifies the effect on consumer confidence. It is also the nature of the media to exaggerate any fall in house prices. For example, it is easy to pick statistics which exaggerate the extent of any fall (e.g. choose certain location, choose a certain month and magnify by 12, confuse fall in prices with fall in house price inflation). However, dire predictions of falling house prices can become a self fulfilling prices. If people believe house prices will “collapse” it will deter many from buying, and therefore, the fall in house prices will be greater.

4. Effect on Economic Growth.

A fall in house prices will reduce consumer spending and AD in the economy. Therefore, this could lead to lower growth. It is possible, it could even contribute to a full blown recession (negative economic growth for 2 consecutive quarters) For example, in 1991-92 house prices fell by 15%; this was a significant effect on causing the last recession of 19991. A fall in house prices doesn’t necessarily cause a recession; there are many other factors that effect growth like investment, government spending; a fall in wealth doesn’t reduce income. However, because of the importance of housing to the UK economy, it is quite possible falling house prices could cause a negative multiplier effect and lead the economy into recession.

5. The Benefits of Falling House Prices

If house prices fall and it causes the expected fall in consumer spending, it is very likely to reduce inflationary pressures in the economy. A fall in the in the inflation rate will enable the MPC to consider reducing interest rates. Note, the MPC doesn’t reduce interest rates to stop house prices falling. – They reduce interest rates because inflation falls below their target of inflation. The fall in interest rates reduces the cost of mortgage repayments. This is good news for those with high mortgage interest repayments. It may also moderate the fall in house prices because falling interest rates make buying a house increasingly attractive. Therefore, if you have no need to remortgage or sell your house, falling house prices can actually be beneficial for many homeowners.

6. First Time Buyers.

Another positive impact for falling house prices is that it will help to make buying a house more realistic for first time buyers. The last decade has seen the ratio of house prices increase much faster than incomes. The effect of this is that many first time buyers struggle to buy. The effect of this is particularly felt in areas like London and the South East. The shortage of affordable housing has caused a shortage of key public sector workers, such as; teachers, nurses and policemen. This is having an adverse effect on local economies. Councils are increasingly look to immigration to fill shortages of nursing. Thus a fall in house prices, or an extended period of flat house prices, would enable the house price to earnings ratio to become better.

7. Depends on the Extent.

Some people confuse a fall in house prices with a fall in the rate of growth. For example, recent headlines about the UK housing market include:

“Big drop in UK house price inflation”

At first glance this may appear prices are falling. However, what they mean is that house prices are now growing at 7% a year, rather than increasing at 9% a year. It is possible that a fall in house price inflation to 1% a year could actually have similar effects to falling house prices. Clearly the impact of falling house prices depends on the severity. A modest fall of 1-2% is not too drastic. A fall of 10% would be very serious.

Evidence in the UK

Evidence from the UK suggests, that a sustained fall in house prices can play a crucial role in causing an economic recession (fall in Real GDP).

During the two big house price crashes of 1991-94 and 2007-08, there was also a recession. Falling house prices were not the only cause of recession, but it was a significant contribution.

Also, it is worth bearing in mind, that the negative economic growth also tends to exaggerate the fall in house prices. When unemployment is rising, demand for buying a new house tends to fall.