What exactly does safe mode do? (Windows 7 and XP)
Safe mode boots Windows with only the bare minimum of drivers and services to get Windows going. It's used mainly in diagnosing trouble with Windows when running normally (e.g. people will ask "does it happen in safe mode?"
You can read more on microsoft.com and Wikipedia.
Safe mode just loads up a subset of drivers, and services - for example, loading generic VGA drivers as opposed to specific ones, and loading network drivers only if asked. On windows XP, i believe 'step by step' mode only loads the drivers you have specifically asked for.