U.S. consumers are keeping the world economy afloat. But they're up to their eyeballs in debt.

By Anna Bernasek

In ancient times, of course, no one had access to credit cards. So when Damocles wanted to attend a sumptuous banquet at the royal palace, he had to agree to some unusual terms. To teach him a lesson about the perilous nature of his desires, King Dionysius had a sword hung from the ceiling over his seat, suspended by a single hair. For the entire feast, poor Damocles had to remain in that precarious position, which would wreck just about anyone's appetite.

Today some economists think the U.S. economy is experiencing its own sword of Damocles: consumer debt. Just as agreeing to sit under that blade allowed Damocles to partake in a feast he really couldn't afford, record consumer debt has enabled consumers to buy--and keep on buying. Now, with business spending, the stock market, and major world economies all in retreat, American consumers alone are keeping not just the U.S. economy but pretty much the whole darned globe afloat. If they handed out medals at the U.N. for such things, American citizens would surely be in line for one.

Let's hope it lasts, because if for some reason Americans stop borrowing, consumer spending will crumble and there will be absolutely nothing between the world economy and one very ugly recession. Worse still, an avalanche of household defaults followed by tight credit could make any downturn drag on--and on and on. So the question is: With the entire world economy perched so precariously, will U.S. consumer debt deliver the final, crushing blow?

Probably not, but before we get to that, let's look at the facts. Consumer debt has sailed into uncharted territory. Household borrowing had been growing steadily since the mid-1980s before positively exploding during the last decade. It now stands at a record $7.4 trillion, almost double what it was at the beginning of the 1990s. Interest payments as a percentage of income have jumped from 2.2% to 3.2% since 1995 even though interest rates themselves have been falling. Debt service as a percentage of income is close to 14.5%, another record. And for the first time in history, American households are carrying a debt burden equal to their combined after-tax income. Obviously, there's a level at which debt-fueled consumption suddenly stops helping and becomes really, really bad for the economy. Trouble is, no one is sure exactly where the tipping point is, which makes it awfully hard to predict how this whole debt thing is going to play out.

What we do know, however, is that it doesn't necessarily have to end badly. In fact, there's good reason to expect that households can get through this period intact. For instance, falling energy prices, tax cuts, and lower interest rates are doing pretty much what you'd expect them to do--boost household income. Even on the employment front, which is the biggest threat to household finances, the outlook is fairly promising. Data for July showed that the number of jobs in the economy was still contracting, but at a much slower pace; meanwhile, the unemployment rate--4.5%--remained near its historic low. And while household net worth has fallen 10% in the past 12 months, it's still close to an all-time high--an impressive $41 trillion, 20% above the historical average.

There are plenty of other reasons to be chipper, and we'll get to them soon. But first let's look at what can go wrong, which, unfortunately, happens to be a lot. For one thing, such extraordinarily high debt levels have made consumers much more vulnerable to financial stress. "The American consumer is like an athlete on steroids," says Robert Manning, author of the book Credit Card Nation and a professor at the Rochester Institute of Technology. "He's artificially pumped up and not as healthy as he looks."

There are already indications that financial stress may be on the rise. Credit card delinquencies are at their highest level in almost nine years, and personal bankruptcy filings are increasing. Some groups are more at risk than others. Low-income households in particular have borrowed up a storm, and one-fifth of them are now classified as heavily indebted (with debt payments above 40% of income), according to the Federal Reserve Bank survey of consumer finances. Homeowners may have taken on a greater risk too. The rule of thumb used to be that a household spent at most 20% of income on rent or a mortgage. Now one in five two-income families is spending more than half its income on housing.

Clearly, these folks need to rein in their borrowing, but if less leveraged consumers also suddenly lose their appetite for debt, the slowdown could take a turn for the worse. In June, U.S. consumer borrowing fell for the first time in 3 1/2 years. And that may already be having an impact: In the second quarter, consumer spending moved back in line with income, after running ahead by about half a percentage point for much of the past decade. The savings rate has also leveled off after years of decline, a sign that Americans are paying more attention to their finances. "There are limits to how much debt people are willing to take on," says David Levy, chief economic forecaster at the Jerome Levy Institute, "and we could be nearing that point." If consumer debt really has stopped growing, it would be hard to match the eye-popping GDP gains of recent years. And in a recession, households may default, setting in motion another negative cycle.

It all sounds pretty scary, we know. Fortunately, the debt picture may be a lot brighter than those numbers indicate. The main reason: While consumer liabilities have increased, assets have skyrocketed in value. During the 1990s boom, strong housing sales and a bull market pushed total household assets to recordlevels. "Worries about debt are misplaced," says Jim Glassman, senior economist at J.P. Morgan Chase. "I don't see that the U.S. household is in any trouble." When viewed in its proper context, Glassman argues, the debt burden is actually quite benign. While total household debt is equal to household income, consumers' overall assets are worth 6 1/2 times that much. So even if some poor souls get into trouble, they should be able to cover their debts with ease.

And just like companies, households can use debt to increase their wealth. It all depends on the reason for borrowing in the first place. For instance, taking out loans to pay for college is surely a better financial investment than buying a giant new flat-screen television. Economists like Glassman argue that since young workers assume that their income will rise over time, it's perfectly rational for them to borrow against that expected stream of future income. "Look at the enormous boost to household wealth from buying a home," says Glassman. "It's clearly been beneficial for households to have taken on that debt."

Besides, the level of debt isn't really a problem for the economy as long as lenders are still willing to lend. About a year ago banks seemed to have tightened up on loans, but since then they have become much more accommodating, according to figures from the Federal Reserve. "We haven't seen any constraint on credit," says Bill Dudley, chief economist at Goldman Sachs. "The lines of credit out there are still huge and available." That means if people do get into trouble, they can borrow in the short term until they get their finances back in order.

Basically, debt on its own can't bring down the economy. What it does do, however, is add another element of risk. "Debt burdens can make a bad situation worse," says Bob Barbera, chief economist at Hoenig. "They work as an amplifier rather than a trigger." For debt to really hurt the economy, there needs to be some kind of shock to household income or wealth. Something like escalating job losses and unemployment soaring over 7% would be bad; so would another big drop in the stock market or a housing market collapse. While any one of those scenarios is certainly possible, none is very likely. Furthermore, during the current downturn, households have already suffered quite a few serious blows and survived. Last year's energy shock was in some ways as severe as the oil crisis of the 1970s, and the Nasdaq collapse was right up there with the worst market corrections in history.

Perhaps the biggest reason for optimism is that several powerful economic forces are now at work that should boost household income. Oil and gas prices have been dropping over the summer, and tax rebates are on the way. Households will soon get back some $50 billion from President Bush's tax cuts. Consumers may react in two ways: First, they may spend their rebate (hey, that flat-screen TV is on sale!), helping to lift the economy out of the doldrums; second, they may decide to pay off debt. While that wouldn't be as powerful a stimulus for reviving GDP growth, it would help folks improve their financial position. That's good news for the economy, provided they don't overdo it.

Finally, interest rates have fallen sharply and are still on the way down. Alan Greenspan & Co. will be meeting again in the middle of August and are widely expected to cut rates by another quarter of a percentage point. That should help lower debt burdens and reduce interest payments even further, giving households a lot more breathing room. Lower interest rates have already helped shrink mortgage payments substantially and encouraged a huge wave of refinancing.

Consider this: Mortgage rates were in double digits during most of the 1980s, and according to Glassman, a family with a typical mortgage faced monthly payments of $881. He calculates that the same amount borrowed today at current mortgage rates would result in a payment of only $675 a month. So while mortgage debt has increased in the aggregate, monthly payments have actually been dropping, which is especially good news for low-income households. It doesn't end there. Even if the Fed stops cutting rates after August, there's no reason to expect any interest rate increases for a long time. And persistent low interest rates will help keep pressure off household income.

So right about now you're probably wondering, what ever happened to Damocles, the guy with the sword hanging over his head? Unfortunately, the legend never really tells us. Unless somebody gave the sword a little jolt, it probably didn't fall, and Damocles feasted at the banquet and went home in one piece. Let's hope that for the sake of the global economy, the same will be true for debt-laden American consumers.