A man walks past Milan Stock Exchange July 12, 2011. The main measure of Italy's borrowing cost broke above 6 percent for the first time in 14 years before easing back on Tuesday as the euro zone's third-largest economy was sucked into the bloc's debt crisis. (Stringer/Italy/Reuters)

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.

Though a limited default could be largely technical in nature — limited to a cluster of European banks that agree to take measured losses or assume the risk of lending to Greece at below-market values in order to help it out of its hole — economists warn even that could turn the embers of investor panic in nations like Italy into flames.

Sensing the danger, European leaders were scrambling to arrange an emergency financial summit to address the crisis, perhaps as soon as Friday.

“What you are seeing is a deterioration of market confidence,” said Thomas Mayer, chief economist with Deutsche Bank in Frankfurt. “Italy is the 850-pound gorilla in the room. The Europeans need to be careful now. It is too big to be saved by the rest of Europe. It is a weight they cannot lift.”

Fears that Italy could be caught up in the crisis have raged for months, but the first significant signs Rome was catching Athens’s malady emerged last week, when investors began dumping Italian bonds and selling off the stocks of banks like UniCredit that are heavily exposed to Italian debt as well as the debt of other troubled European nations.

That accelerated Monday, three days after Berlusconi fueled concerns of Rome’s commitment to passage of $56 billion in budget cuts by making disparaging remarks about his own finance minister, Giulio Tremonti. The cuts also have come under fire from analysts for backloading the worst of the belt-tightening until after the 2013 Italian elections.

Berlusconi — plagued by sex and financial scandals — sought to ease those fears Tuesday, saying the “crisis prompts us to speed up” approval of the budget-cut package and “to bolster its content and draw up additional measures aimed at balancing the budget by 2014.”

Yet Italy, analysts note, is no Greece. Though plagued with slow growth and a massive debt load, Italy is not nearly as profligate, running a relatively modest budget deficit of 4.2 percent of its gross domestic product. Italy also is an industrial powerhouse, home to Fiat and other major manufacturers of automobiles and heavy equipment.

Still, analysts say that saving Italy would not be as simple as a Greek-style bailout, given that Rome needs to refinance a whopping $1.2 trillion in debt by the end of 2015 — dwarfing the pot of cash Europeans, the International Monetary Fund and the European Central Bank have set aside to contain Europe’s debt crisis thus far. If Italy’s situation markedly worsens, analysts say the ECB might need to begin acting like the U.S. Federal Reserve after the U.S. financial crisis — effectively printing money to buy up vast amounts of Italian and other troubled European bonds.

“I think Italy is in a much better position than Greece still, but clearly the Europeans now need to make sure that Italy doesn’t go,” said Jonathan Tepper, partner at Variant Perception, the London-based research firm. “That would be bad, and not just for the Europeans.”

Schneider reported from Washington.