Italy puts the euro in the hot seat

07/11/2011 1:27 pm EST


Jim Jubak

Founder and Editor,

“If I fall, then Italy falls. If Italy falls, then so falls the euro. It is a chain,” Italian finance minister Giulio Tremonti said over the weekend.

The grandiosity of Tremonti’s rhetoric aside, today global financial markets have bought into his logic. The French CAC stock index was down 2.7% as of 11:50 a.m. New York time. The German DAX index was down 2.33%. And the euro was down 1.63% to $1.4032.

Yields on Italy’s 10-year bonds were at 5.55%, a nine-year high, at 1:45 p.m. in London today. That puts Italy perilously close to the 7% threshold that triggered bailout rescue requests from Greece, Ireland, and Portugal.

Why is Italy in crisis today? And why is what happens with Italy so important to the euro?

Italy makes so many bondholders nervous because it is the world’s third biggest debtor after the U.S. and Japan with $2.6 trillion in government bonds outstanding. The country will run a budget deficit again this year that will push debt to 120% of GDP.

Tremonti has introduced a $57 billion austerity package designed to eliminate the budget deficit by 2014. The package is vague on crucial details and depends on other new legislation that won’t necessarily get past parliament. But it is the only game in Rome.

But Tremonti has been cut off at the knees by Prime Minister Silvio Berlusconi. The package has been approved by the full cabinet but Berlusconi has criticized the package as too severe. Berlusconi has also endangered its chances of passing—and raised odds that Tremonti will resign—by saying that he wants to add a clause to the package that would allow his media company Fininvest, to delay paying an award of about $800 million in damages after a court found that a Fininvest lawyer had bribed a judge in the battle to control publisher Mondadori.

This has weakened a coalition government where the Prime Minister faces three concurrent trails for tax fraud, corruption, and sex with an underage prostitute, where the agriculture minister is to stand trial on allegations of links to the Mafia, and where five members of Parliament in Berlusconi’s party have been served arrest warrants on charges of corruption. Tremonti’s political advisor Marco Milanese is one of those five members of parliament.

Italy’s actual financial problem wouldn’t be enough to rattle the financial markets without this political backdrop. Italy’s debt equals an estimated 120% of its GDP, but its current budget deficit is only 4.6% of GDP. That compares to 9.2% for Spain and 7% for France. On the other hand Italy’s economy grew by just 1% in the first quarter.

The fear, though, is that Italy’s political chaos will prevent the country from doing anything to address its debt and budget problems. And that if Italy goes the pressure on Spain will become impossible to resist.

Italy alone may be too big to save. Italy plus Spain certainly is.

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