economics oxford university

economics oxford university

House prices in the UK have been rising at phenomenal rates. However many economist predict in the future house prices could fall. If this were to occur what would be the economic implications and should the government do anything about it?

Arguments for government intervention to prevent house price falls

1. House prices tend to be volatile, this is because Supply and demand are inelastic (if price changes people keep buying them). Also the housing market is subject to speculation, people may buy houses during house price growth to try and profit, however if house prices fall these speculators will be inclined to sell, causing a bigger crash in house prices. Therefore any fall in house prices could have significant consequences for the economy.

2. House prices can adversely affect the rest of the economy. For example if house prices rise quickly then it can cause inflationary pressures to build up leading to a boom and bust economic cycle. If there is a house price crash this will leave many home owners with negative equity. (This means that the house is worth less than what they bought it for.) Therefore this will significantly reduce consumer confidence and therefore a reduction in consumer spending leading to lower growth and possibly a full blown recession.(negative economic growth for 2 quarters)

3. The housing market has a significant impact on the economy, because over 75% of households are home owners and mortgage repayments are a significant part of people's income. Housing is the biggest form of wealth therefore the negative consequences should not be underestimated.

The fall in house prices could also lead to a negative multiplier effect, where the final fall in GDP is bigger than the initial because of the bandwagon effect.

4. Preventing a crash in the housing market will help prevent people have their home's being repossessed. This is because with negative equity and high interest payments people would be unable to pay off their debts.

However there are arguments against the government trying to prevent a housing crash.

1. Firstly it is difficult to predict future house price inflation. For a long time people have argued house prices are overvalued but house prices continue to rise. Therefore it is hard to judge whether house price changes are due to pure speculation or have good fundamental reasons.

2. Housing is a private good, there are alternatives like renting a house.

3. If house prices are overvalued then there are benefits of letting their prices fall. Because it will help first time buyers be able to afford to buy a house, at the moment many key public sector workers are unable to buy. Cheaper house prices would increase efficiency of the economy and increase geographical immobility e.g. easier to buy houses in London.

4. A fall in house prices would reduce house price speculation therefore in the future house prices would be more stable.

5. It is difficult for the government to intervene in the housing market. Interest rates could be cut. But if the MPC cut interest rates it may conflict with other objectives like the governments inflation target of CPI= 2% +/-1

Conclusion there are significant costs to the economy of falling house prices. Therefore if possible the government should seek to avoid house price volatility, however due to the nature of the housing market it is quite difficult in practise to prevent falling house prices once they occur. This is because the government only has limited tools to prevent this. The best option is to try and reduce house price volatility through meeting supply constraints and making mortgages less sensitive to changes in interest rates. i.e. more fixed rate mortgages.

Richard is an economics teacher in Oxford. He has written extensively on economics, the housing market and edits a guide to Mortgages. This site contains information about the state of the UK housing market and offers advice about getting mortgages in the UK.

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