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 due to a negative wealth effect. 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 the end of 2007 was a factor in contributing towards the recession of 2008/09.
- In the early 1990s, UK house prices also fell rapidly due to high interest rates and the end of the Lawson boom. This fall in house prices was also a factor in causing the recession of 1991/92.
Other factors at work
In both recessions 1991 and 2009, there were other factors apart from falling housing prices.
- 1991 – high interest rates and overvalued exchange rate
- 2008/09 – Rising oil prices, financial crisis, fall in bank lending.
Nevertheless, a sharp drop in house prices did affect consumer wealth, confidence and consumers spending.
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 sector.
These factors were reversed when the housing market turned.
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) 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. In the 1991-92 recession, falling house prices caused by a bigger repossession rate because interest rates were also very high.
Benefits of falling house prices
One benefit of falling house prices is that it reduces the cost for first time buyers to buy a house.
Falling house prices 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. 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.
In theory, a fall in house prices would cause first time buyers to need a smaller deposit and therefore, it becomes easier to buy. To some extent, with less need to save for a deposit, first time buyers may be able to spend more on other goods.
- However, it is worth pointing out, that although falling house prices may increase discretionary income for first time buyers. First time buyers are outweighed by the bigger group of consumers who own a house and are more affected by falling prices.
Evaluation of falling house prices
- Depends on the percentage of home-owners.
In 2001, 70% of homes were owner-occupied and therefore consumers would be more affected by falling house prices. But, since 2001, the owner occupied rate has fallen, meaning a smaller share of consumers would be affected by falling prices.