Saturday, July 21, 2007

Falling House Prices

Economic commentators have been surprised that things went on as normal when property prices stopped increasing in England and the United States. This is worth thinking about.

A rise in property prices does not create any extra goods and services. So a property boom is a zero sum game. If some people become wealthy, others must have lost wealth. To understand the effect of the boom, we need to identify the losers.

Everyone has lost a little through the inflation that accompanies the boom. Instead of benefiting from cheaper goods through technological advance, we are all a little worse off than we would have been if there was no inflation. Those who have not invested in property have lost the most.

A few people will have sold their property and left the market. They are the one who have really become rich, provided they do not leave to early.

Most people have sold one property and bought another. They feel more wealthy because the have a bigger and better property, but they also have a bigger mortgage. If house prices fall, their mortgage will be unchanged, but their equity will shrink. They will end up paying the full value of their property, so their gain from the property boom will prove illusory.

The biggest losers are those who buy their first home during the last stages of the property boom. They will have paid an excessive price for their house. A property boom is like a pyramid scam. Those who are last in lose the most.

Even those who are the greatest losers will not be in dire straits. At least they will still own a house that they like. They should still like it, even if declines in value. And they will have planned to make their mortgage payments, so that will not be a problem. Even an increase interest rates should not be an enormous problem, because most will have planned for that as well.

The only fly in the ointment would be unemployment. However, they will probably have two incomes. They might be okay as long as one remains. If necessary, they could change to an interest-only mortgage to survive. The bank would have no interest in selling them up. They would only have a serious problem, if they both lost their employment.

This means that the end of a property boom should not cause serious damage to the economy. Falling house prices are only serious a problem, if accompanied by severe unemployment. It then becomes a ratchet that drags the economy down.

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