If the crisis is not contained, analysts fear profound repercussions for the global economy, up to and possibly including a fresh worldwide financial crisis. A full-blown debt crisis in Italy and Spain would hit large European banks hardest, but it could also dry up lending between financial institutions worldwide in a manner similar to the global credit crunch that started in the United States in 2008.
U.S. banks and investment funds are also more exposed to Italy and Spain than they are, for instance, to tiny Greece. Though U.S. holdings in Italian and Spanish debt amount to $36.7 billion and $47.1 billion, respectively, indirect holdings through derivatives and other financial contracts total an additional $232 billion and $131 billion.
Should Italy’s and Spain’s borrowing rates continue jumping, both nations could effectively be priced out of private markets, leaving the Europeans with limited options. Though Europe, led by Germany, has bailed out Greece, Ireland and Portugal, analysts believe rescues for Italy and Spain would be politically untenable. Outrage is already growing among German, Dutch and Finnish voters in particular over current bailouts. And in a worst-case scenario, Italy alone would need $1.2 trillion to cover its borrowing for the next three years — or six times the amount for Greece.
Instead, analysts believe that the European Central Bank would need to step in with a massive program to buy up Italian and Spanish debt to drive down their borrowing rates, while extending more liquidity to big banks in both countries. But if such a program went on too long, it could risk undermining the euro and triggering a dangerous bout of inflation.
On Wednesday, European leaders appeared mostly frustrated with investors, who they insisted were overreacting.
“Developments in the sovereign bond markets of Italy and Spain are a cause of deep concern,” Barroso told reporters. “These developments are clearly unwarranted on the basis of economic and budgetary fundamentals in these two member states and the steps that they are taking to reinforce those fundamentals.”
Berlusconi also appeared unbowed, saying the markets were grossly underestimating Italy’s fiscal health. In fact, though the country’s debt burden is massive — with $2.2 trillion in debt, Italy is deeper in the red than the United States compared with the size of its economic output — its annual budget deficit is running at a relatively modest 4 percent. Unlike Greece, it also boasts a massive industrial base with heavy manufacturing.
But investors have nevertheless tired in recent months of trusting indebted nations to pay their bills, and with signs of slower growth in Europe, some fear that Italy may not be able to meet its budget targets. Some critics also view a recently approved austerity plan there as being too little, too late. Berlusconi offered them scant reason for more comfort, providing no outline for any additional cost cutting.
The cloud over Italy and Spain also reflects political uncertainty. Spain, where a backlash to austerity is growing, will hold early elections in November. In Italy, the 74-year-old Berlusconi is still embroiled in sex and financial scandals. He has also publicly warred with his finance minister, Giulio Tremonti, a man who is seen as Italy’s economic compass but who is battling a fresh scandal over his financial links to a top aide mired in a corruption probe.
“Berlusconi is more interested in his bunga-bunga parties than his bond market,” said Louise Cooper, a markets analyst at BGC Partners in London. “Having a very public row with your finance minister is just extraordinary. But this is what you come to expect from the man.” The latest data raise concern “that euro-zone growth is rapidly ebbing and in real danger of grinding to a halt,” said Howard Archer, an economist with IHS Global.
At the same time, the latest sign that growth is slowing across Europe emerged Wednesday, with data showing the service sector weakening on the heels of earlier signs of a slowdown in regional manufacturing.
Special correspondent Karla Adam contributed to this report.