The downward spiral in the residential housing market has been the main culprit behind the slowing Arizona economy. While unemployment rates have not yet started to climb, the negative “wealth effects” of falling home prices have weakened consumer confidence and undercut spending.

Never mind that home prices increased by more than 75 percent between 2004 and 2006. Professor Karl Guntermann of the W.P. Carey School of Business reports that the Repeat Sales Index for Phoenix housing is down 11 percent since the July 2006 peak. Consumers put more weight on recent trends, and so far there is no end to the price declines in sight.

Meanwhile, higher gasoline prices and tighter credit conditions have affected homeowner budgets. The combined result has been to make consumers become more cautious about big ticket purchases. Restaurants, movie theaters and other consumer discretionary categories have also seen cutbacks as worries about the economy mount.

The housing downturn has a more direct effect on real economic measures such as production, jobs, wages and incomes. The pace of new home construction has fallen in the Valley, and as builders reduce output to try to control inventories, jobs are lost and ripple effects begin to take hold.

Fewer single-family homes built means fewer families taking out mortgages, replacing furniture or buying new yard tools. If fewer homes are being built, suppliers of materials cut back their operations and truckers have fewer deliveries. It all adds up to lost jobs, and when jobs are lost workers reduce their spending, leading to the kind of economy-wide slow down afflicting the Valley, Arizona and most of the rest of the nation.

Last year, the dollar value of Valley residential building was down by $1.5 billion. This decrease of 23 percent in residential building was accompanied by a decline in construction employment of 24,000 jobs, or 10 percent.

Why not more? Because at the end of 2007, non-residential building was still going strong, with an offsetting $6 billion of construction in the form of office, commercial and industrial space, as well as public spending on schools, infrastructure and roads. While single-family housing permits have declined every year since 2004, the dollar value of non-residential building in Phoenix has continued to post double digit growth rates, such as the 20 percent in 2007.

But that’s why more real estate trouble likely lies ahead. Non-residential construction may be the next shoe to drop, and it may have the same effects on employment and economic activity as the residential slump we are now experiencing.

Previous residential downturns in Arizona always have been accompanied by dips in non-residential activity, but not necessarily coincident in time. In the recession of 2001, single-family permits were flat in 2000 and 2001. Non-residential activity turned negative in 2002 and was flat in 2003.

Observers point out that the run-up in Phoenix home prices may have contributed to the need for more non-residential building. As housing prices escalated, consumers began to consider the trade-off between paying less for homes farther out from the central core in exchange for longer commutes. But these areas didn’t have supporting retail and public infrastructure, which has been built over the last three or four years. Now, those farther out areas are the most distressed, with higher foreclosure rates and falling home values. Higher gas prices also are affecting resales in outlying areas. Don’t look for continued expansion of retail and other commercial building in those areas until the residential markets stabilize.

The longest residential slump in recent times was the four-year drop that started in 1987, and did not correct until 1991. Non-residential building declined during that same period, but the non-residential downturn lasted longer, through 1992.

First quarter figures for 2008 show that resales and new home sales are still very sluggish. According to the Realty Studies at ASU’s Polytechnic campus, resales were 11,390, the weakest first quarter since 1998. And the Arizona housing recession continues.

The current residential downturn could well extend into five consecutive years of residential housing declines, to be followed by a non-residential slowdown of unknown length, depth and impact on an already weakened economy.

Lee R. McPheters is a professor of economics and senior associate dean of the W. P. Carey School of Business at Arizona State University. He is also director of the JP Morgan Chase Economic Outlook Center. For more information visit wpcarey.asu.edu.