UK house prices are falling like a stone. Will that make Britain poorer? If so, how?
First let us eliminate a case in which people are wealthier - say, because their future income growth expectations are higher - and therefore spend more on their houses. Then rising house prices would be the consequence of higher wealth, and similarly falling house prices might be the consequence of lower wealth, but the change in the house prices would not itself be the driver of greater or lesser wealth. In such a case falling house prices might be the symptom of lower wealth, but would not be the cause - falling house prices would not make Britain poorer.
Instead, we want to consider whether falling house prices could be the cause of reduced wealth. I shall argue that they can, but only in a very limited, almost irrelevant sense. The key effects of falling house prices will be on the construction sector, there will be a "liquidity effect", there will be an intergenerational transfer effect, and there will be an effect upon inflation. But there will be almost no causal effect upon wealth. I shall explain.
Suppose that everyone in the country had in their possession a number of gold bars, with that number being proportional to everyone's income. Then suppose that the price of gold doubled overnight. Would everyone have become wealthier? To be sure, people might think they were wealthier. After all, yesterday their personal balance sheets had only £X in the gold bars column, whilst today they have £2X. So if they failed to understand that everyone else were in the same situation, then they might have the illusion of wealth. But suppose that everyone went and tried to spend their extra £X. What would happen? Well, the productive capacity of the economy as a whole has not risen, so there would just be more money chasing the same amount of goods. Result: inflation.
There would be some effects other than inflation, though. The extra X on their balance sheets might allow some people that would intend and have the capacity to pay back loans to use their gold bars as collateral. So there would be a liquidity effect. There would also be an intergenerational effect - those whose current income were very high but were not going to rise any further yet (the late middle aged) would gain at the expense of those whose incomes would rise further in the future (the young), because the number of gold bars at the outset was proportional to current income. There would also be an effect upon the gold mining industry - at a higher gold price, it would become more attractive to dig up extra gold, so employment and output in the gold mining industry would rise.
There would be one last effect. If Britain had a disproportionately high amount of the world's gold, then a rise in the world gold price would mean that Britain had become wealthier relative to other countries.
Almost precisely the same logic applies to housing. Although if one person's house becomes more expensive relative to other houses, that person has indeed become wealthier, if all houses become more expensive (but the housing services provided by those dwellings are unchanged) that only has an effect upon overall wealth in the country insofar as it means (if it does) that Britons gain at the expense of foreigners - it enables us to sell our British houses and buy bigger houses abroad.
This argument is much the same as that Adam Smith offers in the Wealth of Nations as to why it is a mistake to think that it is the accumulation of gold that makes a nation wealthier. Smith argues, instead, that it is the value of all the output of the country that is crucial.
Falling house prices will doubtless be associated with all kinds of misery - negative equity, limited labour mobility, liquidity constraints, bankruptcies, and the like. But, overall, in the long term it makes almost no difference to the country's real wealth whether house prices are very high or very low.
