A look at the economic impact of falling house prices.
Readers Question: Explain why a decrease in the price of houses can lead the economy to experience a recession.
In summary: falling house prices reduce consumers’ main form of wealth. This tends to cause lower spending and lower economic growth. Falling house prices tends to have a significant impact in the UK because of the relative importance of the housing market.
The sharp fall in house prices from March 2008 was a factor in contributing towards the recession of 2008. (though the recession also contributed to the fall in house prices. The two factors are interlinked)
- In the early 1990s, UK house prices also fell rapidly due to high interest rates and the end of the Lawson boom.
In the boom years (1999-2007), rising house prices:
- Increased the confidence of householders to spend / borrow and reduce savings. This led to strong growth in consumer spending and was one of the main factors behind UK economic growth.
- Rising house prices enabled consumers to re-mortgage their house and take out equity withdrawal (get a bigger loan against the value of the house. This enabled more spending
- Encouraged construction
Falling House Prices and Negative Wealth Effect
When house prices are falling rapidly, there is a negative wealth effect.
- Consumers see a fall in their main asset. This decline in wealth causes lower spending and higher saving.
- Many consumers are trapped in ‘negative equity’. This occurs when the value of the house is less than the price they paid for it. This awareness of negative equity discourages people from borrowing and encourages them to save. A rise in the saving ratio will cause lower consumer spending.
This graph from the Bank of England shows the inverse relationship between wealth and the saving ratios. When house prices fell in 2008, there was a sharp rise in the savings ratio from 0% to 5%
- Equity withdrawal tends to dry up when house prices fall. This means householders have less income to spend. e.g. equity withdrawal put an extra £14bn into UK economy before housing crash. But, by end of 2008, equity withdrawal was -£8bn (meaning people were saving to pay off mortgage early.)
- Falling house prices has a significant impact on consumer confidence. It is worth stressing the importance of the housing market to the economy. It is one of the most widely discussed statistics (frequently makes front page headlines, e.g. Daily Mail and Daily Express) a sharp drop in house prices is often symbolic of an economic downturn.
Falling House Prices and Banks
Falling house prices also have an adverse effect on the banking and financial sector. Falling house prices mean banks will lose money if people default from their mortgage payments. These bank losses lead to lower bank lending and lower investment.
The scale of bank losses depends on the default rate. In the 2008-09 recession, the rate of bank default was relatively low because interest rates were close to zero.
Benefits of Falling House prices.
Falling house prices could be good news for first time buyers who are priced out of the market. It helps rebalance the housing market. However, the tightening of mortgage criteria means, in practise, it is actually no easier to buy a house.
Related
(originally published Dec. 2008 – updated Dec. 2011)
Is this because lenders are unwilling to finance, causing less people being able to buy??