One good index of how overvalued house prices are is to compare prices to average earnings. Nationwide provides a useful time series of house prices going all the way back to 1983. They also calculate the ratio of prices paid by first time buyers to average earnings. I have put these figures on the chart below.
The first observation is that the ratio is still higher than at the peak of the 1980s bubble.
A second point is that during the last downswing there were occasions when the ratio ticked up - eg Q2 1991 and Q4 1994.
The average ratio is 3.3. First time buyers pay 3.3 times the average earnings, on average. Currently the ratio is 4.2. If the ratio is to return to its historic level then prices have another 21% to fall relative to earnings. Of course, if wages rise quickly then prices need not fall so far.
Another look at the chart shows that after the last housing bust, the ratio overshot the average and fell to a low of 2.1. In Q4 1995 first time buyers were only shelling out about twice average earnings. To fall back to that level, prices would need to fall by half or wages double.
What does this mean for the economy. Falling house prices have a "wealth effect". People feel poorer and decide to save more, postponing consumption and so reducing demand. At present government spending is lifting demand but the stimulus packages will begin to run down next year. The household spending which will be needed to keep the recovery going may not materialise.