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News - 17 July 2008

House price decline – why does it matter so much?

House prices continue their slow decline, house builders are in serious trouble and mortgages plumb new depths as lenders hoard their cash. Why do house prices matter so much in the UK?

With just 42,000 new mortgages issues in May – about half the figure compared to 2007 – it came as no surprise that the Bank of England has warned that lenders intend to restrict new mortgage lending even further over the next three months.

This will exacerbate the decline in house prices and make it harder for those on fixed rate deals to re-mortgage and raising the prospect of negative equity for a substantial number of home owners.

There are three main reasons why house prices matter so much and have such a dramatic effect on the wider economy. Firstly the construction of housing represents a huge investment and the expected reduction in housing starts (they fell by 24% in the first quarter) will wipe one percentage point off GDP both this year and in 2009.

Secondly the reduction in housing starts and moving house for existing owners will reduce the demand for consumer goods related to property transactions. Moving house is typically associated with the purchase of an array of new products for the home. This could reduce GDP by a further three tenths of a percentage point.

The last reason might seem obvious but is actually a matter of some contention. It is tempting to conclude that, as house prices decline people feel less wealthy and therefore spend less but the Bank of England has cast some doubt on this theory.

Consumers did not respond to the increases in house prices in the early years of this decade by spending substantially more and similarly they would not appear to have responded to falling prices over the past six months by spending substantially less (see earlier story).

There is a theory that confidence in the future is a more important factor when people are deciding how much to spend and this is dependent upon not just house prices but also employment prospects and unemployment rates.

These too are in decline and unsurprisingly consumer confidence is starting to slump which may see a further half of one percentage point knocked off GDP as they buy less.

Taking all these factors together the effect on the wider economy is significant although the consensus of opinion is that it will not be as bad as the previous housing slump because interest rates are considerably lower although the effects of rising fuel and food prices are a new factor this time round.

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