(FORTUNE Magazine) – At the normally cheerful Starbucks on Peachtree Road in Atlanta, the pulsating beat of Red Snapper captures the jitteriness of the times. The music evokes the same edgy feeling you get watching the numbers crater on the Nasdaq. At the cash register, a towheaded boy in a soccer jersey tells his mother he wants the marble pound cake instead of a muffin, at which point his mom does an odd thing. She turns to the cashier with a question that seems curiously out of place in this upscale coffeehouse in a tony neighborhood: "How much more does it cost?" After she is told that the cake, like the muffin, is $1.85, she acquiesces.

Rob Ciampa and his wife, Laura, are grappling with bigger decisions. Rob was one of the founders three years ago of NetEffect, an Internet engineering firm. Although the company is still growing, the Ciampas have postponed a home renovation. And instead of spending spring vacation in Florida with their two sons, they stayed in Atlanta to take day trips. Laura, a former ultrasound specialist, is returning to work. Even before the economy slowed, she had decided to start a business providing health counseling to women over 35. Now, says Rob, "we have the motivation to really get going. What started off as a hobby or a passion" is turning out to be more serious.

For several months, the concerns of people like the Ciampas have sent consumer confidence careening down at an alarming rate. But the puzzling part is this: There continues to be a large gap between the pessimism people feel and the reality of their lives. Sure, they have had paper losses in the stock market, and they read about layoffs almost every day. But most people have not lost their jobs. The value of their homes has not declined. The economy is not in a recession. The Federal Reserve has been cutting interest rates, making it easier to buy new homes and refinance old mortgages. Although consumers are worried, they continue to spend. Car sales have slowed, but not as much as expected. In January home sales were strong, and retail sales rose; in February retail sales slipped.

What will people do in these uncertain times? Reading their minds is not just an academic exercise. Consumer confidence--and what it portends for spending--is the single biggest factor standing between a mere downturn and a full-blown recession. Fed Chairman Alan Greenspan has made no secret that he is paying close attention to consumer spending levels. Consumption accounts for about two-thirds of GDP. It has been the willingness of people to fork over not just $5 for a latte and a muffin at Starbucks but $50 for an afternoon of skateboarding at the Rampage Extreme Sports Park, $10,000 for a family ski vacation at Aspen, or $100,000 for a home renovation that has kept the economy so strong for so long. On the one hand, economists want the spending spree to continue. On the other, they know that people are overextended. That's called a catch-22.

Two closely watched surveys of consumer confidence are unnerving. The Conference Board index sank to 106.8 in February, from a peak of 145 last May, the lowest level since 1996. The University of Michigan index has fallen 15.8 points since November. It climbed about one point in the latest survey, released in mid-March, though another index out the same week from ABC News/Money declined. Economists won't rest easy until they see several months of stable-to-rising numbers. "It's much too soon to think we've seen the lows on consumer confidence just because it bounced up a little bit," says First Union economist Mark Vitner.

The so-called worry gap--the difference between how people assess their current situation (not so bad) and their expectations of the future (increasingly pessimistic)--has grown. The nowhere-to-go-but-up feeling that prevailed for so long (call it irrational exuberance) seems to be giving way to an equally pervasive sense of gloom. The plunging stock market has frightened almost everyone, especially the people who know they spent too freely when times were good. Now they're haunted by what could happen if things go bad.

The fears are not unfounded. "There are very real reasons for people to be very nervous right now," says Juliet Schor, a senior lecturer at Harvard and author of The Overspent American. "They are going into this downturn more heavily indebted than ever." Too many people are perched precariously atop living standards supported by lines of credit and depreciating assets. Consumer credit grew at a 12.5% annual rate in January, up from 5.5% the month before. And the ratio of household net worth to disposable income declined from 6.3 to 5.8 in 2000. "We have a lot of households out there that are one car problem, one health crisis away from cratering," says Bruce Brittain, a financial services market researcher who has surveyed consumers about their use of credit. "We're coming into that time where those chickens may come home to roost."

Dismal as consumer confidence already is, it has a long way to fall before it reaches the level of the last recession, which began in 1990. The next six to eight weeks will be critical. If confidence continues to decline over that period, spending will contract sharply. In that case, the first recession of the 21st century seems inevitable, as corporations react by further reducing investment, cutting production, and laying off workers (for advice on coping, see "Surviving the Downturn").

The rising gloom scares consumers into pulling back, and the bad news feeds on itself. So far the Fed's interest rate cuts have helped support the housing market. But in a recession, real estate would take a hit. On the job front the layoffs have already started, but additional ones are coming. That will lead to more fear. Would rapid passage of President Bush's ten-year, $1.6 trillion tax cut make consumers feel more flush? Hardly. For all the debate over the size of this cut--and its possible effect on the budget surplus--it will put just a pittance into most families' pockets. The cuts in individual tax rates will make a significant difference to rattled two-income, upper-middle-class families, but not right away--and the economy needs an immediate jolt.

On and on it goes. Many of the people who lose their jobs and have trouble paying their debts will declare bankruptcy. The lenders who get burned will squeeze credit, which tightens the chokehold on spending. As Americans shop less, exporters from Europe and Asia will be sucked into the economic black hole; Japan, the world's second-largest economy, is already there (see "Monster Problems"). At that point, U.S. investors won't be the only ones screaming in pain and rage (see "They're Mad As Hell...").

Admittedly, this is a worst-case scenario. If we're lucky, we won't get there from here. At Bank One in Chicago, chief economist Diane Swonk remains essentially optimistic. "Don't bet against the consumer," she says. "As long as they have money to burn, they'll burn it. I'm still coming down on the side of actions speaking louder than words." Home sales have been strong, and mortgage refinancings are surging. "You only do that if you're feeling confident," says Swonk. Still, even she acknowledges that "consumer debt is higher than it's ever been. If the economy really does crater, will there be big repercussions for consumers? Absolutely."

To get a sense of the foreboding, hang out and eavesdrop. Here in Atlanta you overhear nervous conversations at the White House Restaurant, at the Patrick Lindsay boutique, at the Windsor Parkway soccer fields. This is a big-spending city, where the best-known landmarks are the malls and you are what you drive. But if pressed, plenty of people admit to being overextended. They took the easy credit that was offered almost every time they opened the mail or answered the phone.

Now, like so many others, Atlantans are unsure about how much to keep spending and how much to batten down the hatches. So they do a bit of both. They go out to lunch but order just the salad, skip the entree, and water to drink, please. At the Patrick Lindsay boutique, a Buckhead matron flips out her plastic just like old times, but then asks for a receipt and sheepishly explains, "I have to show my husband. I'm now required to show all my receipts to my husband. I'm actually not even allowed to be in here." Beth Egan, an Internet marketing director, used part of her bonus to pay off a credit line and put the rest in conservative investments. "I'm not treating myself to anything," she says. "We were all so bullish a year ago. We're all experiencing shattered dreams. We've all been sobered."

The rising stock market made for giddiness all around. Optimism was fueled by oh-so-much hype about the Internet. The media chronicled the rags-to-riches tales, making them seem so easy. Who wanted to be a millionaire? Practically everyone. In a sign of the optimism and/or insanity of youth, 77% of college students polled in 1999 by KPMG said they expected to become millionaires. Wow! No wonder so much money was burning through the pockets of all those casual khakis.

Stocks can have a major impact on the economy through the so-called wealth effect. As stocks rise and people feel richer, they're willing to spend more--about four cents for every dollar increase in household net worth, according to one estimate. (The reverse is also true--and often more extreme. Over time, says Mark Zandi, chief economist of Economy.com, people spend roughly six cents less for every dollar decrease in net worth.)

In the latter half of the gay '90s, something else contributed to the spending orgy. Almost imperceptibly, salaries--yes, boring old salaries--began to show consistent gains for the first time in 30 years. Spendable wages and salaries grew by 2% in 1997, 4% in 1998, and 2.8% in 1999, according to Swonk. That may not sound like much, and compared with all the Internet wealth, it wasn't. But small changes in personal income can have a big effect on how people act. For example, sluggish household income in the '70s was a major reason so many women joined the work force. And during these past few years the extra income made people feel affluent, whether or not they had much to do with the technology boom or the stock market.

The problem was, their spending increased faster than the size of their paychecks. Swonk says that household debt as a percentage of disposable income rose to 33.6% in 1999, from 29.2% in 1990 and 22.8% in 1984. At the same time the savings rate declined from 8.3% of disposable income in 1991, to 4.8% in 1996, to slightly below zero last year--the first time the savings rate has ever been negative. It is projected to continue at a negative rate at least through next year, according to Bank One.

Some economists have argued that the savings rate, defined as the gap between disposable income and expenditures, doesn't take into account money "saved" through appreciating assets like houses and stocks, or the contributions companies make to employees' 401(k) plans. If assets appreciate, the thinking goes, there is less need for old-fashioned savings. Ironically, the very nature of the new savings--which fluctuate with asset values--may now be snuffing out consumer confidence.

Stocks, real estate, and 401(k)s are not cash flow. The same thing that happened to so many dot-coms during the recent gold rush happened to consumers too: They forgot about cash flow. "Cash flow didn't matter," says Nicholas Hoffman, senior vice president of Balentine & Co. and a money manager in Atlanta. "People had assets. But now their assets are way down, and the liability is real. Their lifestyles require cash." This is so not only for Hoffman's high-net-worth clients but also for people in less rarefied tax brackets.

Spending patterns changed dramatically during the past decade. For starters, new technology produced all sorts of expensive "necessities": cell phones, home computers, high-speed Internet hookups. And social change redefined the meaning of keeping up with the Joneses. "You had a shift in reference groups--how people defined and compared themselves," says Schor. White-collar professionals quit comparing themselves with their neighbors--who knows or cares about neighbors anymore?--and instead used their work colleagues or their college friends as reference points. But the neighborhood model was much more realistic, since the value of your house is the best measure of your economic status and spending power. Keeping up with professional friends meant that college professors and marketing directors were trying to live like lawyers and investment bankers.

For a few years, thanks to credit cards, it all seemed possible. Consumer credit was a great leavener of the '90s, a way for salesmen to live (almost) like bankers. Not that credit cards were new; in the mid-1980s, 43% of families had at least one. But ten years later technology had made it possible to charge everything from your groceries to your doctor's bill. As credit card lending became more profitable, banks and other companies marketed it aggressively and enticingly. They managed to dramatically alter attitudes about debt. "Credit became a way of life," says Leenie Ruben, chief strategist at NextResearch, a marketing and consulting firm. "It became okay to charge things. And the credit card gave everybody a feeling of wealth." It allowed people to do things they couldn't do with their paychecks.

By 1998, 68% of families had credit cards. Even more telling was the free and easy way they used them. "First you charge your Domino's pizza, then you charge your $350 muffler job, and all of a sudden you owe somebody $10,000, and you can't quite figure out how it happened," says Jay Lawrence Westbrook, the chair of business law at the University of Texas law school and one of the authors of The Fragile Middle Class: Americans in Debt. Credit cards led to a blissful detachment from cash flow. Juliet Schor says they enabled people to live without budgeting. Between 1990 and 1999, average credit card debt per household rose from $2,985 to $7,564, according to CardWeb.com.

As worries about debt fell away, people began to tap the equity in their homes more aggressively. They made smaller down payments and took out more home equity loans. When they refinanced to take advantage of lower interest rates (as many are doing now), they often got a new mortgage bigger than the one they retired--plus a stash of cash. The number of these "cash-out refis" has soared to as many as 80% of all refinancings. Mark Zandi says the average amount of the cash-outs rose to $19,900 last year, from $14,500 in 1993.

In 1998 (the latest year for which figures are available), one-third of the cash-outs went toward home improvements; 28% to pay off other debt; and 18% to consumer expenditures like cars, vacations, and education or medical bills. "The net result is a fairly significant erosion in the equity that people have in their homes," says Eric Belsky, executive director of Harvard's joint center on housing studies. "The value of homes has been going up significantly, but the share of equity is going down. So that's a clear indication that people are borrowing pretty heavily against their homes."

Consumer credit is a bit like heroin. Two years ago Brittain Associates surveyed 4.2 million homeowners who had taken out home equity loans and used some of the proceeds to reduce their credit-card debt. Nearly three-quarters paid off everything, an amount that averaged $6,900. But 11 months later 70% had run their debt up again to $2,100. At that rate, says Bruce Brittain, they would be in the same-sized hole within three years--with one big difference: "They're going to have a home equity line to pay down too."

Right now, the refinancings and the cash-outs are buoying the economy because they give consumers more cash to burn. As Zandi notes, "the refinancing wave could very well turn out to be instrumental in forestalling a more severe economic downturn." But he and other economists also see a darker side. By increasing their mortgage debt, writes Zandi, "cash-out refiers are weakening their balance sheets, making them more vulnerable to future financial problems." Furthermore, the erosion of home equity has occurred during the most robust part of the business cycle, leaving people less of a cushion for harder times. Says Belsky: "What you hope is that people have some equity that they can borrow against in the event of a downturn to meet immediate requirements."

In Atlanta, signs of softness are all around. Starbucks has begun selling its $399 espresso machines for $100 less. It's much easier to get a reservation on short notice at Bluepointe, a chic restaurant. Houses are taking longer to sell, even in the high-end neighborhoods. During evening soccer practice at Windsor Parkway, the sideline chatter has turned from cheery conversation about children to hushed talk of layoffs. One mother says her next-door neighbor, an engineer, was laid off last week. So was a college art professor from her synagogue. Everybody knows there is no such thing as corporate loyalty anymore. A decade ago layoffs were so controversial that they were euphemistically referred to as restructuring. Now they're just business as usual.

It doesn't take much to figure out why confidence is plunging. The stock market has collapsed. Could housing prices be next? Will jobs disappear? Consumers keep hearing that the economy depends on them to keep spending. And they're tempted. But they also know they've taken on scary amounts of debt. No wonder they're sending mixed signals. They're damned if they don't spend--and they could be damned if they do.

REPORTER ASSOCIATE Julie Schlosser RESEARCH ASSOCIATE Patricia Neering

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