Europe’s escalating debt crisis is on the verge of engulfing by far its biggest victim: Italy, the world’s seventh-largest economy, whose sheer size could thwart any international attempt to bail it out.
Italy has been deeply indebted for years, and its woes have generated a burst of investor panic in recent days amid concerns of political infighting in Rome over budget cuts. Italian bank shares have been battered, and the nation’s borrowing costs have skyrocketed to dangerous levels.
More than anything else, investors appear to be losing confidence in the ability of bickering European leaders to come up with a lasting solution to the 20-month-long debt crisis, triggering a perilous spread of the region’s financial woes from small nations such as Greece to the far larger economies of Spain and now Italy.
The addition of Italy to the so-called PIGS of Europe — Portugal, Ireland, Greece and Spain, financially troubled nations on the brink — marks what economists say is a serious escalation of the stakes. If fears of a collapse in minnows like Greece have rattled world markets in recent months, a full-blown crisis in Italy — the third-most-indebted nation in the world — could have a devastating effect, potentially triggering another worldwide credit crunch and reversing the global economic recovery.
“The crisis in confidence that has battered financial markets and hit Italy in recent days is a threat for everyone,” Italian Prime Minister Silvio Berlusconi warned Tuesday.
U.S. officials have for months urged Europe to take more forceful steps that would “ring-fence” the debt crisis to smaller countries and create confidence that larger nations such as Italy and Spain would not be endangered.
That is because a full-blown crisis in Italy would be an order of magnitude worse. Italy is the euro area’s third-largest economy and a member of the G-20 group of major economic powers. And its deep connections make it a potential source of financial contagion: German and French banks have about $36 billion invested in the government bonds of Greece, but they hold nearly $150 billion in Italian debt. U.S. investors, including big banks, directly hold $36.7 billion in Italian debt.
On Monday, initial signs of Italy being swept up in the crisis contributed to the biggest global stock sell-off since March. Though the stock market in Milan clawed back from deep losses early Tuesday after a moderately successful sale of Italian debt, European markets from London to Paris to Frankfurt lost further ground on lingering fears that the region’s debt crisis is about to get worse.
On Tuesday, European financial leaders gave some investors more reason to fret. Bitterly divided over how and whether to extend additional rescue funds to near-bankrupt Greece, officials meeting in Brussels appeared to be no longer ruling out a limited Greek default that would affect some investors. That puts European financial officials largely at odds with the European Central Bank, which has argued that such a move could be disastrous.