Here's a big story that didn't happen: The U.S. economy did not collapse, dragging down the rest of the world. Considering all the bad news (the stock and tech bubbles, Sept. 11, corporate scandals, the Iraq war), it might have. The escape from calamity had many causes, including optimistic American consumers and the Bush tax cuts. But none mattered more than the Federal Reserve's policy of cheap credit. Alan Greenspan and others have now signaled that its days are numbered. What comes next? The fear is that everything puffed up by cheap credit (including housing prices and stocks) will go flat. The hope is that the recovery no longer needs the crutch of cheap credit.

A crutch it's clearly been. From Jan. 3, 2001, to June 25, 2003, the Fed reduced its overnight interest rate (the federal funds rate) from 6.5 percent to 1 percent -- the lowest in more than four decades. The cuts worked. In a recession, auto sales and housing construction typically suffer. Not this time. "We didn't lose the jobs in automobiles and housing that we usually lose in a recession," says economist Allan Meltzer of Carnegie Mellon University. Because automakers could borrow cheaply, they could lend cheaply (aka buyers' "incentives''). Car and light-truck sales slipped only slightly, from 17.3 million in 2000 to 16.7 million in 2003.

Housing did even better, because mortgage rates declined from an annual average of 7.5 percent in 2000 to 5.8 percent in 2003 (on 30-year fixed-rate loans). Home construction rose from 1.57 million units in 2000 to 1.85 million in 2003. Millions of homeowners also refinanced existing mortgages at lower rates. They reduced monthly payments, shortened maturities or borrowed more against rising housing values, which were pumped up by low mortgage rates. Since the end of 2000, household debt has increased a third, to $9.4 trillion. The extra cash financed home improvements and more shopping.

All this helped offset corporate cutbacks. After the economic boom, companies had surplus workers and investments -- factories, machinery, offices. To restore profits, they cut payrolls and investment spending. Cheap credit also helped this recuperative process. It enabled businesses to reduce interest costs and refinance short-term debt at favorable rates. Among large nonfinancial corporations, interest costs dropped from 20 percent of cash flow in 2001 to 14 percent in 2003, reports the Fed.

Finally, cheap credit went global. As Americans spent, U.S. imports rose. Dollars flowed abroad. When those dollars arrived elsewhere, they were often converted into local currencies by foreign central banks (the Fed's counterparts). America's easy money fostered easy money abroad, particularly in Asia. "Central banks have colluded . . . to keep the global economy afloat," says Robert Gay of Commerzbank Securities.

What's tricky is that, except for the overnight federal funds rate, the Fed doesn't control any interest rate. Banks, pension funds and others actually set market interest rates (on mortgages, business loans, bonds) based on their views of inflation and risk. When the Fed cuts the funds rate, it simply buys U.S. Treasury securities from banks and others. The cash used to pay for those securities gives banks more lending funds, which -- other things equal -- could reduce other rates. The Fed succeeded because inflationary expectations were subsiding and because the Fed itself reduced the perception of risk.

It influenced long-term rates by encouraging the "carry trade'': Investors borrow short-term money at low rates (say 2 percent) and lend it at higher long-term rates (say, 5 or 6 percent). A lot of that happened. From 2000 to 2003, bank lending rose about $1 trillion. Banks used cheap deposits to buy mortgages and bonds. As more money moved into these investments, their interest rates fell. But the carry trade is risky: if short-term interest rates rise, it can become unprofitable. So, last year the Fed reassured investors. The Fed funds rate would stay low for "a considerable period," it said. The Fed shaped "expectations of long-term bond investors in a very creative way," notes Mark Zandi of Economy.com.

Unfortunately, cheap credit cannot last indefinitely, because, once the economy improves, it will rekindle inflation: too much money chasing too few goods. Worsening inflationary psychology will push up market interest rates. With better job growth, Greenspan and the Fed have reached this juncture. The Fed has withdrawn its "considerable period" pledge and indicated that the Fed funds rate will soon rise from 1 percent. Market interest rates have already increased, because views of inflation and risk have deteriorated. In mid-March, the rate on a 30-year fixed mortgage was 5.4 percent; now it's above 6 percent.

What's unknown is the economy's ability to withstand higher rates. One favorable sign: about 80 percent of household debt (mainly mortgages) is at fixed interest rates, estimates the Fed. Most borrowers won't be hit with higher monthly payments. Another good sign: Corporate America has experienced a shakeout. The survivors have restored profitability and captured sales from weaker competitors; they're expanding. But dangers lurk. Higher interest rates could lure money from stocks. Tighter credit could spread abroad. Higher interest rates could hurt auto sales, home construction and real estate values. Borrowing against higher housing prices will drop. In 2003 household debt was already 113 percent of disposable income; in 2000 it was only 97 percent. Overborrowed consumers could become more cautious.

For Greenspan, this may be his last hurrah; by law, his Fed appointment ends in early 2006. The Fed needs to raise rates fast enough to prevent market rates from taking off -- and slowly enough not to choke the recovery. It's a delicate maneuver. By pulling it off, Greenspan would ensure his reputation.