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Housing risks

A sustained fall in house prices would do economic damage
August 15, 2017

The long upward trend in house prices has ended. According to the Halifax index, house prices have fallen by 1.4 per cent so far this year. And the RICS says there are signs that the fall in London prices is “permeating outside the capital”.

Most economists think this won’t develop into a full-blown slump simply because an acute lack of supply will underpin prices. But this isn’t certain. The causes of the current wobble (a lack of affordability and Brexit uncertainty) won’t go away quickly. And there is often momentum in house prices: rises lead to buying in anticipation of further rises, and falls to less demand in anticipation of further falls. The Bank of England’s Financial Policy Committee recently warned that buy-to-let investors “may look to sell their properties quickly, reinforcing house price falls in a downturn.”

We should therefore ask: what would happen to the economy if prices do continue to fall?

Raw correlations tell us that falling house prices are associated with recessions. Since 1991, the correlation between annual changes in real house prices and in real GDP has been a hefty 0.62.

Correlation, however, is not causality. This strong association is due at least in part to the fact that the same things that cause house prices to fall also depress GDP: higher interest rates, tighter credit, pessimism about future incomes and so on.

Would a fall in house prices without these factors be so bad for the economy?

You might think it would, simply because lower house prices mean lower wealth and hence less spending. This isn’t clear, however. Of course, house prices are wealth for homeowners planning to trade down – for those whose house is part of their pension. But they are a liability for younger people who don’t own homes and who want to get on the housing ladder. These will have to save less hard for a deposit. In effect, they'll enjoy a positive wealth effect from falling house prices, which might offset the adverse wealth effect upon older homeowners.

This doesn’t, however, mean we can relax.

One problem is that falling house prices will be accompanied by a decline in housing turnover, and this means less spending upon housing-related items such as furniture and carpets. DFS is already suffering from this.

Behavioural economics says this won’t be offset by higher spending on other items. When you move house, you tend to raise your spending because of a framing effect: having spent £300,000 on a house, another few hundred pounds looks like small beer. Fewer house moves mean fewer such framing effects and hence less spending overall.

There’s more. Housing is collateral. High house prices allow people to take out second mortgages to start or expand new businesses, or simply to consolidate other debts. As prices fall, so does this collateral which in turn means less bank lending. That means fewer business start-ups and hence less economic growth. And it might also mean more financial distress and personal bankruptcies if loans cannot be rolled over.

These risks are exacerbated by the fact that interest rates are at rock bottom. That means the Bank of England can’t use lower interest rates to support house prices or bank lending.

We should, therefore, worry about falling house prices. As IMF researchers have said: “Of the 46 systemic banking crises for which house price data are available more than two-thirds were preceded by boom-bust patterns in house prices.” The FPC has warned: “Housing has been at the heart of many financial crises.”