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American debt explosion: The good, the bad, and the ugly

February 18, 2014

FORTUNE — Americans are busting out their credit cards again in a big way. According to the Federal Reserve Bank of New York’s Household Debt and Credit Report, consumers took on $241 billion in new debt in the fourth quarter of 2013, the largest quarterly increase since 2007.

Though overall debt levels remain below their 2008 peak, the jump in debt is further evidence that consumers have largely shaken off the effects of the recession and that their appetite for debt will help fuel economic growth.

But wasn’t it too much debt that helped create the financial crisis? Well, yes, but debt is complicated. There’s good debt, there’s bad debt, and then there’s downright ugly debt.

So, what does the Federal Reserve’s data say about the state of the economy in 2014?

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The good

While we often focus on the dangers of too much debt, debt is necessary for a modern economy to grow. Economist Richard Koo of the Nomura Research Institute has explained how debt factors into a normal, healthy economy:

Consider a world where a household has an income of $1,000 and a savings rate of 10%. This household would then spend $900 and save $100 … the saved $100 will be taken up by the financial sector and lent to a borrower who can best use the money. When that borrower spends the $100, aggregate expenditure totals $1,000 … and the economy moves on. When demand for the $100 in savings is insufficient, interest rates are lowered, which usually prompts a borrower to take up the remaining sum. When demand is excessive, interest rates are raised, prompting some borrowers to drop out.

But following a financial crisis, the economy doesn’t behave this way. After the real estate bubble burst, for instance, the value of assets for both businesses and individuals fell considerably. In response to this, both businesses and individuals used what income they had to pay down debt, rather than taking out debt at all. Continues Koo:

In the world where the private sector is minimizing debt, however, there are no borrowers for the saved $100 even with interest rates at zero, leaving only $900 in expenditures. That $900 represents someone’s income, and if that person also saves 10%, only $810 will be spent.

It takes years for individuals and businesses to repair their finances following a financial crisis, so this dynamic can continue for many years, with the economy growing steadily worse all the while. That’s why the recent increase in consumer debt is a good thing. It means that individuals have finally repaired their personal finances (at least in the aggregate) and feel like they can start borrowing again. In this situation, the economy can really begin to grow again.

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The bad

Looking more deeply at the report, however, there are signs of the bifurcation of the American economy. Mortgage debt, for instance, continued to decline for Americans with the lowest credit scores, likely due to foreclosure activity. Of course, one would think that individuals with lower credit scores would have limited access to borrowing, but the fact that less creditworthy borrowers have difficulty securing home loans of any kind — regardless of the interest rate — shows that the American housing finance system is still on the mend, and low- and middle-income Americans are not seeing a sufficient increase in income.

The ugly 

Those with low credit scores are racking up the debt, however, in the student loan category. As you can see from the chart below, the largest percentage increase in any category represents people with low credit scores taking out student loans.

There’s nothing inherently problematic with less creditworthy individuals taking out student loans. If the debt is being put toward useful education that will help boost a borrower’s income down the road, the investment could be considered very wise. The problem is that it’s not entirely clear that the people who take out student debt are investing that money well. The chart below shows delinquency rates for various types of loans, and student loan delinquency is on the rise.

Unlike most private loans, the main issuer of student loans — the federal government — issues such debt without taking into account the monetary value of the degree being sought. Whereas a small business must submit a business plan to a bank to receive financing, a student can get financing from the federal government without providing a plan for repayment. And these delinquency rates rates suggest that many students will be unable to pay, and because of bankruptcy laws, they will not have the option to discharge that debt in most circumstances.

At its core, the banking sector gives capital to consumers and businesses who can use that money in a productive way. But the federal student loan program doesn’t act like a bank. Instead, it directs funds based on need and desire. If so much of the rising personal debt burden is being driven by this kind of lending, it raises major concerns for the U.S. economy going forward.