House Prices And The Wider Economy

By Author: Alex Richards
Total Articles: 65
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In 2007, the world banking crisis began following incredibly irresponsible lending in the US housing market. The practice of lending was called ‘sub-prime' lending, meaning that banks were lending to ‘sub-prime' borrowers, i.e. those who were unlikely to have the income to pay their mortgages. This was OK for a while, especially for the bank bosses, who received huge bonuses for their irresponsible risk taking.

But as soon as house prices stopped rising, negative equity levels rose sharply, leading to repossessions and huge losses for banks. Even banks who hadn't been heavily involved with this type of lending felt the effects as the major world banks relied heavily on each other for funding.

The crisis quickly spread to the UK and across the world. Even though the banks were bailed out through billions of pounds of taxpayers' money, they have continued to be reluctant to lend to both people seeking mortgages and businesses alike. Why? Because they have become more afraid of risk and have had to build up their reserves to protect themselves from future liquidity problems.

The UK government ...
... has been claiming that they will reform the banks and get them lending more again, but three years later little action has been taken. By December 2008, house prices had fallen by a record 16.2% compared to December 2007.

The fall in house prices wasn't just because fewer people could get the mortgages they required in order to buy a house, but because house prices are closely linked to the wider economy for a number of different reasons.
Interest rates are one important factor in determining house prices. The Bank of England sets a base rate which banks tend to follow when lending to individuals and businesses. And when the economy fails, as it did so dramatically when the banking crisis hit, the Bank of England is likely to decrease its base rate to encourage borrowing (as it is cheaper) and discourage saving (as the rate of return is lower), with the central goal of boosting consumption and the housing market.

This happened in December 2007 - but notice the date - as mentioned above, house prices fell dramatically from this point. Two key reasons were given for the ineffectiveness of the Bank of England's actions. Firstly, the Bank of England responded too late, and secondly, as mentioned earlier, the banks rely on each other for funding.

They have their own interest rate at which they lend to each other, called the LIBOR. Unfortunately, because the banks remained cautious about lending to each other, the LIBOR remained high, so any money they lent for mortgages cost more for them to get in the first place.

Another factor affecting house prices is consumer confidence. When the economy is weak, confidence is low - people worry about their job security and their income falling and consequently are more cautious about spending and borrowing. With fewer people borrowing a mortgage, demand falls in comparison to supply, and house prices fall.

In addition, the ratio of income to house prices is another factor. House prices became very high in relation to average incomes in the UK, and they are still considered too high. The fewer people that can buy properties, the lower demand is, meaning house prices should readjust and fall.
Expectations of house prices also have an influence. As the economy has been weak, people have had lower confidence in the housing market and have therefore delayed buying property, expecting that they will be able to get a cheaper price if they wait. This, again, limits demand and prices.

Following a brief recovery in house prices between mid 2009 and mid 2010, prices have began to fall again, prompting fears of a stagnating housing market for many years to come. With house prices being so closely linked to the economy, could this indicate something worrying about the economy - are we in for a double-dip recession?

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