If house prices fall significantly, they will not just leave homeowners with negative equity, they will also cause serious economic consequences for the wider economy.

These are some of the most important factors.

1. Negative Wealth Effect.

Homeowners will see their major asset (housing) decline in value. Some who bought recently will see negative equity (House is worth less than mortgage value). Therefore, they will have less confidence to borrow and spend; they will try to increase the value of other savings, leading to a decline in consumer spending. Householders will find it more difficult to remortgage, especially for the purpose of equity withdrawal. Therefore, there will be a significant fall in spending caused by equity withdrawal. In the 1990s and 2000s equity withdrawal played an important role in boosting spending and growth in both the UK and US.

2. Fall In Aggregate Demand. / Economic Growth

Because of the lower confidence and lower consumer spending there will be a fall in aggregate demand. It is worth pointing out that housing is a significant determinant of spending in the economy. Consumption accounts for 66% of AD, and housing is by far the biggest form of wealth. Housing has also become an important barometer of the state of the economy – House price falls make front page headlines.

The fall in spending and aggregate demand leads to lower economic growth and possibly recession.
Lower growth will also increase unemployment.

3. Lower inflation Rates.

The slowdown in consumer spending will reduce inflationary pressures in the economy. This may enable the MPC to cut interest rates as it will be easier to maintain the inflation target of 2%.

Evaluation

The impact depends on other variables in the economy. For example, if there was an increase in exports and  or government spending, then AD may continue to rise. However, at the moment, the underlying prospect of the UK economy looks weak. Industrial output and investment show signs of weakness.

Inflationary pressures may not fall because at the moment there is cost push inflation factors. For example, rising oil and food prices is pushing up the inflation rate despite a slowdown in the economy. This makes it difficult for the MPC to cut interest rates because inflation is going above their target. Therefore, they will be unable to cut rates to help consumers and the housing market.

In the US, the government have tried very hard to avoid a recession. Government have cut taxes, and the Fed have cut interest rates to 2%. So far the US, have just about avoided a recession.
House prices fell in the early 1990s by 15%, this was a significant factor in leading to a recession in the UK. see: History of Housing Market