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Can Britain really cope with a fall in housing prices?

Britain is locked in a seemingly constant battle with the burden of its overheated housing market. Theresa May has announced measures at the Conservative Party conference designed, at the very least, to dampen criticism over a lack of housing and ever-increasing prices.

It is unclear for now just what impact May’s announcement for land releases and an extra £2 billion for affordable housing may have. After all, the UK’s housing stock is valued at close to £7 trillion. But her announcement comes after London real estate prices registered their biggest fall in a decade, stoking expectations for further drops in real estate prices.

But what would falling house prices mean for Britain? How might it affect employment, household consumption, investment, the government deficit and, critically, the UK current account – the net measure of cash flows in and out of the economy.

The greater fool

Brexit and associated uncertainty about the future of the UK financial sector are making real estate investors, home buyers and households more cautious. One of the things that has fuelled London real-estate prices over the years is the “greater fool” mechanism. Buyers knew that a property was expensive, and perhaps ridiculously expensive, but they counted on the fact that they could sell it later to a “greater fool” at an even higher price, for a handsome profit.

That phenomenon was perhaps best displayed in the first recorded crisis in free markets. Tulip mania in 17th century Holland built to a crescendo which saw single, rare tulip bulbs change hands for extraordinary sums. Historian Mike Dash has described it as enough to “purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash, complete with a coach house and an 80 foot garden”.

As tulip mania went on to show, however, if prices show indications of a fall, the upward trend reverses violently. If property investors become skittish, they will try to sell before prices fall further, and all of them at the same time. Property values built over decades could collapse within months: the expectation of falling prices causes the falling prices.

This mechanism is a real danger in London which relies heavily on local and international investors who view properties not as a home but as a commodity, readily sold to maximise profit. In 2013 alone, international investors accounted for 82% of London property activity.

Falling for it

However, most properties in the UK still belong to households. Families, by and large, don’t need to sell. So what would falling property prices mean for them?

First, many pension funds and investment bonds rely on UK property to generate income for their beneficiaries. Second, we have what economists call the Wealth Effect.

Economists have long associated consumers’ perceived real estate wealth with spending behaviour: if you believe your house is worth a lot, you feel financially secure. And then you allow yourself to save less and spend more. Just consider the rising number of people who plan to subsidise their retirement with wealth generated by their homes.

If their assumed valuations start to look shaky, these people will spend less to build up their savings. The pain would be felt by many: about 64% of households in England are owner-occupiers.