Impact of House Prices on the UK Economy

Impact of House Prices on the UK EconomyWhat happens to habitation prices is perceived as being very important for the wider UK saving (at the moment the concern is that they may fall sharply). Consider to what extent kinsperson prices are important for the UK economy and how the government (or Bank of England) should respond to a sharp fall in dwelling prices.IntroductionThe health of the residential property market is seen as a very important factor in the UK economy, and house prices have modernisen dramatically (though unevenly around the country) mingled with 1996 and 2005. Some analysts argued that this was the result of a bubble in the housing market, rather than due to purely economic reasons, while others argued that the rise in prices was a rational reaction to gamey employment, economic stability and low interest rates. The price rises slowed in 2005 and that led some analysts to predict a sharp fall in prices. These fears proved unfounded, as renewed growth since late 2005 has led most analysts to predict modest price rises in the modal(a) term. However, many analysts remain concerned that housing prices may fall sharply in the near future.This essay will first consider the different shipway in which house prices in an economy relate to (and impact on) the writ of execution of that economy much broadly, outlining in particular the specificities of the UK housing market that shop its prices peculiarly important to the UK economy. It will then examine the policies the government (or Bank of England) could adopt in response to a sharp fall in house prices, assessing which of these would be the most appropriate. Finally, it will similarly consider some longer term policies which could reduce house price volatility and the impact of house prices on the wider UK economy.The alliance between house prices and the wider economyThe most obvious way in which house prices affect the wider economy is through their impact on household aspiration (Cameron 20054) a fall in house prices, for example, makes home baseowners feel less wealthy so they tend to reduce consumption. Furthermore, a fall in house prices also reduces consumption indirectly by making it harder for people to borrow. Credit constraints are increased through two key channels (1) reduced house prices agent homeowners have reduced collateral against which they can borrow, further reducing consumption and (2) lending institutions make losses when housing prices fall, and so they reduce their lending or tighten their lending policies.According to Oswald (19992), an economys natural rate of unemployment depends on the ease with which its citizens can move around to find jobs. Fluid societies have efficient economies. proud house prices and a relatively small private rental market make it more difficult for people to move around to find jobs, and indeed can contribute to unemployment.House prices can also have an indirect effect on the exchange rate, which is a particular concern because it may give out to a crash in house prices. High house prices contribute to richlyer(prenominal) levels of household indebtedness which can be associated with increasing the current cipher deficit. This, in turn, may suddenly trigger a correction in the exchange rate. If the exchange rate is weakened, a sharp rise in flash and interest rates may follow, leading to a sharp fall in house prices.House prices and the UK economyAccording to Cameron (20053), the high level of house ownership in the UK means that households are exposed to a considerable amount of risk (almost half a million households had their homes repossessed in the 1990s). Not simply are house prices more volatile in the UK than elsewhere in the developed world, the impact of house prices on consumer spending is also particularly obtuse in the UK according to the OECD, a 1% fall in UK housing wealth correlates with a 0.07% fall in consumer spending. The nature of the UK housing mar ket (typically high loan to value ratios, few long-term great dealed rate mortgages, and easy to re-mortgage) makes house prices particularly volatile and responsive to interest rates. Cameron (20053) explains that a one component point rise in the short-term real interest rate would reduce house prices over a five year period by 2.6% in the UK, 1.8% in the US, and 1.3% in Germany.The UK housing market is characterized not only by a high level of home ownership and typically high loan to value mortgage ratios, but also by an insufficient housing affix. Demand consistently outstrips supply and the market is not sufficiently responsive, principally due to the limited land available for construction and the difficulties in obtaining planning permission for new buildings. Constrained housing supply leads to increasingly unaffordable housing, frustrating the home ownership aspirations of many individuals and families. It also leads to wealth redistribution from those outside the hous ing market to those inside it. Low housing supply reduces labour mobility, damaging the flexibility and performance of the UK economy and key public services, and can also translate into wider macroeconomic instability. (HM Treasury 20059)Barker (20043) explains her view of the importance of the housing market to the UK economy more broadly Volatility in the housing market, in the UK, combined with the strong association between house prices and private consumption (reflecting in part high levels of owner occupation) is striking. Consequently, the housing market has contributed to macroeconomic volatility, creating a more difficult environment for businesses and for economic policy makers.Responding to a sharp fall in house pricesIn order to respond to a sharp fall in house prices, the main tool which the government or central bank has at its disposition is financial policy. If there is a sharp fall in house prices, consumption can be expected to drop (as per the relationship betwe en house prices and consumption outlined in the first section of this essay) and there is a danger that a recession with ensue. In order to prevent this, the financial Policy Committee of the Bank of England should respond to any such fall by reducing interest rates, even though this may not be compatible with meeting their inflation target. This should help house prices to grow again, thus building up wealth and promoting consumption. Further, it will make credit more hearty which will also encourage consumption.Longer term policiesRather than being forced to respond to a sharp fall in house prices, the British government, or the Bank of England, would be better off developing longer-term strategies to prevent such a sharp fall in the first place that is to say, they should be proactive rather than reactive. Cameron (20054) argues that it may be possible to make the UK housing market behave more like the US housing market (i.e. to make prices less responsive to interest rates an d less volatile) if the share of long-term fixed-rate mortgages could be increased (even when UK borrowers do take out fixed-rate mortgages, they tend to only fix the rate for three to five years).According to the OECD (20053), the risk of a sharp fall in house prices has been significantly reduced, and this has been achieved by longer term monetary strategies. If a relatively soft landing in the housing market has indeed been achieved it owes much to the strategy of gradual preemptive monetary tightening, in attach contrast to previous episodes when an abrupt correction in house prices was triggered by sharp interest rate rises. Nevertheless, reforms are needed to make housing supply more elastic to damp future housing market cycles. Furthermore, Miles (200497) argues that in order for monetary policy to be most effective in stabilise the currently volatile housing market, the UK mortgage facilities also need to be improved, and borrowers should be better informed.ConclusionBecau se house ownership levels are high in the UK, and because houses represent most households biggest asset, house prices are particularly important to the UK economy. As it currently functions, the UK housing market is insufficiently flexible to respond to, and reflect, the needs of the economy as a whole. Fortunately a drastic fall in house prices is unlikely in the near future. To prevent one in the ordinary to long term, the government should consider increasing the flexibility of the housing market. This could be achieved through relaxing planning regulations and adapting the mortgage market.ReferencesBarker, K. (2004) Review of housing Supply Delivering perceptual constancy Securing our Future Housing Needs, Final Report Recommendations (downloaded from http//www.hm-treasury.gov.uk/media/053/C7/barker_review_execsum_91.pdf on 26 February 2007)Cameron, G. (2005) The UK Housing Market Economic Review (downloaded from http//hicks.nuff.ox.ac.uk/users/cameron/papers/ukhousingmarke t.pdf on 22 February 2007)HM Treasury (2005) Housing Policy An Overview (downloaded from http//www.hm-treasury.gov.uk/media/296/69/housing_policy190705.pdf on 26 February 2007)Miles, D. (2004) The UK Mortgage Market Taking a Longer-Term View, HMSO (downloaded from http//www.hm-treasury.gov.uk/media/80DDF/miles04_470.pdf on 22 February 2007)Muellbauer, J. Murphy, A. (1997) Booms and Busts in the UK Housing Market, The Economic Journal, Vol. 107, No. 445. (Nov., 1997), pp. 1701-1727OECD (2005) Economic Survey of the United Kingdom, 2005 (downloaded from http//www.oecd.org/dataoecd/18/34/35473312.pdf on 24 February 2007)Oswald, A. (1999) The Housing Market and Europes Unemployment A Non-Technical Paper, Warwick University (downloaded from www2.warwick.ac.uk/fac/soc/political economy/staff/faculty/oswald/homesnt.pdf on 27 February 2007)Wadhwani, S. (2002) Household Indebtedness, the Exchange Rate and Risks to the UK Economy, Bank of England speech delivered to the Macclesfield Chamber of Commerce on Monday, 25 prove 2002 (downloaded from https//164.109.43.50/publications/speeches/2002/speech166.pdf on 22 February 2007)