If we look at the experience of Japan, United States, Ireland or Spain, it seems the experience of Britain is unusual. Countries like Japan and the US had a boom and bust in  house prices, similar to the UK. However, the fall in house prices has been more pronounced and longer lasting in other countries.

Given the weak state of the UK economy and financial sector, it is perhaps surprising house prices have recovered so strongly.

Several Factors would normally be lowering house prices

• House price to earnings ratios are still above long term averages.

• Unemployment is rising
• The economy is very slowly recovering from its deepest recession since the 1930s
• Banks are still reluctant to lend mortgages because of lack of finance.

Yet, despite these factors, figures from Rightmove suggested the annual rate of house price inflation was 6.1%. Prices rose 3.2% in the month to February alone. Rightmove measure asking prices, though other house price surveys such as Nationwide paint a similar picture.

There is every possibility that house prices could stop rising and start falling again – especially if the recession lengthens and there is significant job cuts in the public sector.

Yet, at the moment, the combination of – low interest rates and a relative shortage in supply is pushing house prices higher.

It is this shortage in supply that I feel is the main the reason for fact British house prices have stopped falling. In Spain, US and other countries, the boom in house prices, led to a boom in house building. Therefore, they have depressed demand and excess supply. – which hopefully all students would know is a recipe for falling prices.

In the UK, demand is still relatively weak, but, the excess supply is not there – a legacy of the UK’s strict planning regulations.

In the long term, what it suggests is UK house prices will remain expensive – meaning people who want to buy a house will have great difficulty saving for a deposit.

Related

• Why Have house prices stopped falling?

In a recent post, we suggested that after two years of falling prices, the market has turned and now prices are starting to rise. – house price rise

This rise in house prices may prove short lived, and looking at this graph we can see why. Although house prices have fallen 25% from their 2007 peak, they are still relatively expensive. This graph shows the ratio of house prices to earnings for first time buyers. At a ratio of 4.0, this is considerably higher than the post 91 slump when the ratio fell to a little over 2.0.

Low interest rates are helping to make it attractive to buy a house because mortgage interest payments are relatively low. Also, prices are being kept high, by a relative shortage of properties on the market. – This is in contrast to countries like Spain, Ireland and US – where a glut of unsold properties are pushing prices down further.

House price to earnings Ratio over past two decades

Of course, the house price to earnings ratio doesn’t have to fall to historical averages. A continued shortage of supply and low interest rates could mean house prices rise, despite the fact they are still unaffordable for many.

All of this will come as no comfort to those hoping to be able to buy a house at an affordable price.

UK House Prices

When Nationwide began its survey of house prices in 1952, the average house price was £1,891.

If house prices had grown inline with inflation. Average house prices today would be worth £43,711.

However, despite recent 25% slump in house prices, average UK house prices stand at over £150,000.

Many predicted that this year, UK house prices would continue to slump by 10-40%. But, rather unexepectedly, prices have begun to stabilise.

This could just be a temporary pause before the downward trend is continued. On the other hand, some feel that the shortage of housing in the UK could keep prices high, despite the gloomy economic situation.

House prices are certainly not rising because of a surge in demand. In fact for many first time buyers, housing affordability remains poor. The ratio of house price to earnings is far higher than at the end of the last boom.

I wrote a detailed post with graphs and commentary on – Why House Prices have stopped falling – and whether this is likely to be temporary or permanent.

Estate agents will get lower commissions. (typically may get 1% of a house sale, so lower house prices reduce their income. This is made worse because falling house prices often lead to lower transaction volumes. Therefore many estate agents could go bust in 2009.

Banks are less willing to lend mortgages. This is because with falling house prices there is a greater risk of negative equity. Therefore banks tend to prefer offering mortgages which require large deposits. This makes it difficult for first time buyers and reduces the number of first time buyers coming onto markets. This slows the whole market down.

Consumers less willing to buy. With house prices falling, less people want to buy. It makes sense to delay purchasing a house until they have stopped falling.

Fall in house prices leads to less construction building causing less profits for construction firms

Falling house prices often lead to rise in rents as people rent rather than buy. However, with falling house prices, many buy to let landlords are renting out. Rentable incomes have not increased significantly.

Effects of falling US house prices

Effects of fall in UK house prices

The sharp fall in economic output and consequent rise in unemployment will have the effect of further depressing house prices and demand for buying houses.

1. Negative growth and unemployment will contribute to a rise in repossessions. Therefore, there will be more forced sales onto the market; this increase in supply will mean lower prices
2. Also, the fear of being made unemployed will deter people from undertaking a big spending decision like this. People will prefer to wait until economic conditions improve.

Some factors will weigh against this. For example, the lower economic output has led to a big cut in interest rates. This has reduced mortgage interest payments and therefore made buying a house more attractive. Lower interest rates should also prevent more home repossessions.

Another issues is that house prices started to fall even before output started to decrease. In other words there are many microeconomic factors reducing house prices. Therefore, the fall in economic output has exacerbated these other factors that are causing lower house prices.

The key issue is a lack of mortgage credit. Because banks are struggling to raise enough money, they have become very cautious about lending this is causing a shortage of first time buyers.

Falling house prices mean lenders are nervous to lend because of negative equity. It also means consumers are nervous to buy (also because of negative equity)

• Overvalued housing markets
• House prices and recession

• Basically we noted the phenomena that rising house prices often cause an increase in demand and falling house prices cause lower demand. This seems to contradict the basic law of demand. But, I suggested this was due to shifts in the demand curve.
• However, yesterday afternoon I was on a long bike ride (50 miles in under 3 hours) With little to do about from curse the slippery mud on the winter roads, my mind went back to the question and I thought of a different perspective.
• Suppose, you are looking for a place to invest your money. You think one of the best ways to judge an investment is to do what everyone else is doing (this investment strategy has its obvious flaws, but, many people do seem to follow it).
• Therefore, if shares, bonds and gold are doing badly you will avoid them. However, if house prices are rising then they are perceived to make a good investment. Therefore the rise in house prices encourages investors (or speculators) to buy. A good which is rising in price therefore attracts more demand because people think it will give capital gains. So in that sense you could say it is not so much that the demand curve is shifting but, that it slopes the wrong way.
• An individual house will still be subject to a usual demand curve. But, housing in general will not.

The Law of Demand

One of the first things you learn in economics is the basic law of demand – When prices rise, people buy less. When prices fall, people buy more. This seems intuitive. If HMV cut the price of CDs, they would probably see an increase in sales.

However, sometimes, markets appear not to follow this basic principle.

One example, is the market for real estate (housing in UK). When prices are rising it attracts buyers into the market. Rising prices encourage people to buy because

• It makes real estate look a good investment
• A small deposit can soon be increased into a big deposit.
• It is easier to get mortgage finance.

When house prices start falling, the number of buyers sharply falls. This has occured in both the US and now the UK where the number of potential buyers has sharply fallen.

It appears that higher prices encourage people to demand more. Lower prices encourage people to demand less.

However, for any point in time the law of demand is still true. What happens is that in a housing boom the demand curve is shifting to the right. People want to buy more houses at any given price. The demand curve has shifted to the right because:

• People think buying a house has become attractive
• It is much easier to buy, because lenders are offering various attractive mortgages (therefore effective demand is shifting to the right)
• Higher confidence

When house prices are falling, lenders don’t want to lend mortgages without a big deposit. Therefore, it is hard to buy a house – even if you wanted to. This causes the demand curve to shift to the left.

Also consumers are less willing to demand a house when prices are falling because they think it will be cheaper in the future.

But, suppose you are having difficulty selling your house at the moment (because the demand curve for housing is shifting to the left) then if you cut the asking price, the number of prospective buyers would increase and you are more likely to sell your house. Therefore, this shows that the law of demand does apply in the short term.

Even in a boom, if you increased the house price above the market average, you would have more difficulty selling it.

It is also worth bearing in mind that the Supply for housing is usually very inelastic in the short term. Therefore, if the demand curve shifts to the right, it will cause a big rise in price.

• Boom and Busts in Housing Markets

Lower house prices reduce consumers main form of wealth.

In the boom years, rising house prices:

• Increased confidence to spend / borrow and reduce savings. This led to strong growth in consumer spending and was one of the main factors behind economic growth.
• Enabled consumers to remortgage their house and take equity withdrawal. This enabled more spending
• Encouraged construction

Now house prices are falling rapidly, these factors are reversed. Consumers are spending less and there is a deep recession in the housing market. It is also worth stressing the importance of the housing market to the economy. It is one of the most widely discussed statistics and the sharp drop in prices has symbolised the economic downturn.

The bad news is that house prices are liable to keep falling for the foreseeable future, perhaps bottoming out in 2010. This reduces the effectiveness of expansionary fiscal and monetary policy.

See: When Greenspan was nearly God – and the growing impotence of Monetary policy

With house prices falling rapidly, it is interesting to examine who loses and who gains.

This kind of question frequently comes up on AQA unit 3 housing market. However, it also makes an interesting macro economic question.

The Impact of Housing Wealth on economy – detailed look at impact of housing wealth on macro economy.

Effect of falling house prices on UK Economy

11 Reasons house prices are falling

Joining the Euro involves a common monetary policy. This means that UK interest rates will be set by the ECB. Therefore, if the ECB have to increase interest rates it will increase UK rates and therefore increase the cost for UK homeowners. If interest rates increase at the wrong time it could cause economic hardship for homeowners.

1. Mortgages are a high % of consumer’s disposable income and therefore are sensitive to changes in interest rates. UK House prices are a high ratio of average incomes. Many homeowners have had to take out mortgages 4-5 average incomes to get on the property ladder. This means mortgage payments are a high % of disposable income. If interest rates increase, it could make mortgages unaffordable.

2. Variable Mortgages. In the UK, a high % of mortgages are variable mortgages as opposed to fixed rate. Therefore, a change in rates has a big effect on homeowners and therefore, the housing market.

Also, the UK has a  high % of homeowners compared to the continent where more people rent.

Basically, the UK Housing market is very sensitive to changes in interest rates.