What do higher house prices mean for the wider economy?

What do higher house prices mean for the wider economy?

A curious feature of the past decade has been the consistent rise in UK house prices, often in defiance of the wider economic climate. 

The societal impact of such a relentless gallop forward in asset prices is widely debated, but those focused on the economic impact generally fall within two camps. 

Many, such as US economist Dean Baker, say higher house prices ultimately benefit everyone in the economy, including those who are not homeowners, due to the “wealth effect.”

This is the idea that people will spend more of their actual income, because the rise in their perceived wealth (the rise in the value of their house) increases their confidence about their own future prospects, and so encourages more spending and less hoarding of cash.

Nobel Prize winning economist Milton Friedman advanced the theory of permanent income, advocating the view that individuals' spending levels today are a function of what they expect their future wealth to be, that is, in his phrase, the “permanent income” level. 

Friedman’s view was that people’s confidence in their spending habits today is influenced by their notions of what their long-term prospects are, rather than their immediate level of disposable income.

His view contrasts with that of John Maynard Keynes, a British economist who argued that consumer spending could be influenced by a boost of shorter-term income gains to consumers from an increase in government spending.

House prices have consistently risen in the decade since the global financial crisis, partly as a result of the policy of quantitative easing, which is rooted in wealth effect theory.

In the first place, QE increases the volume of money in circulation, and pushes interest rates down.

Lower interest paid on cash deposits means individuals are incentivised to look elsewhere for returns, with the cash going potentially into property and stock markets.

The wealth effect would then kick in, according to its advocates, as people noticing the rise in the value of their house would feel wealthier and be more inclined to spend their income, and so generate extra demand in the economy, which boosts the economic prospects for everyone. 

Rising house prices may also serve to aid the recovery of an economy from recession, as banks have the value of the house they have issued mortgages against.

A general rise in house prices therefore makes the balance sheets of banks healthier, and enables them to loan more cash into the real economy, without falling foul of banks' regulatory requirements to keep a certain proportion of their assets in cash or other liquid assets.

Silvia Dall’Angelo, senior economist at Federated Hermes, is among those who is sceptical of the ability of QE to generate a wealth effect to create growth.