Forget Greece, Spain: The euro stops at Italy

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Forget Greece, cast aside Spain. The European debt crisis story is becoming all about Italy and it's putting mild-mannered professor and prime minister Mario Monti, the country's would-be saviour, in the global hot seat.

Italy, often dismissed as a "peripheral" euro zone country, is anything but. It is the euro zone's third-largest economy, roughly similar in size to Britain's and bigger than Canada's. It is the second biggest manufacturer, after Germany. It is at the very heart of the euro zone and great lover of the common market and common currency. The Treaty of Rome, signed in 1957, is the forerunner to the European Economic Community that begat the European Union and later the euro itself.

Italy also matters because it is drowning in debt (though its budget deficit is among the lowest of the large European countries). With almost €2-trillion in national government debt, it, in raw terms, is the world's third-most-indebted country, after the United States and Japan. With a debt to gross domestic product ratio of 120 per cent, it is, relatively speaking, the second-most-indebted country in Europe, after Greece. And Italy could get shut out of the private debt markets as its sovereign bond yields return to unsustainable levels -- recently, they were close to 6 per cent.

Europe could not afford to save Italy, end of story. Italy's financial collapse could easily trigger a European depression and a deep global recession, or worse.

Italy has always carried high debt, and gotten away with it. But this time is different because its economy is in the tank and the jobless rate is shooting past 10 per cent. It is also surrounded by ailing or effectively bankrupt countries -- Greece, Spain, Portugal -- which are in no position to soak up its exports. Ditto most of the rest of the EU, each of whose 27 countries has austerity programs of varying intensity. As Italy's exports shrink, so does its manufacturing base. Every essential piece of data -- household spending, job creation, consumer and business confidence, bond yields, you name it -- is going in the wrong direction. The Bank of Italy expects GDP to contract by 1.5 per cent this year, but the figure could be worse, and certainly will be worse if Greece and Spain get crunched.

As the state economy and finances deteriorate, Mr. Monti, who replaced Silvio "What crisis?" Berlusconi in November, is losing popularity and political support as his save-Italy programs come up short. Notably, structural reform -- that is, making Italy more competitive, has stalled -- and the growth programs are clearly inadequate. There is no growth. Professions remain closed shops. One in three young people has no job.

Like Greece, Italy too is running out of time. It needs a deal quickly to spare it from the meat grinder. On Friday, in Rome, Mr. Monti hosts a summit of the euro zone's four biggest economies, led by Germany. Next Thursday, he's part of a European summit. Will he nail anything down at these events?

Possibly. Mr. Monti's idea, supported by the new French president François Hollande, is to use the €440-billion rescue fund, called the European Financial Stability Facility, to buy sovereign bonds in the market. The idea is to force down yields, and thus the borrowing costs, of stressed-out countries. The European Central Bank has bought sovereign bonds, but not in great quantities and has shown no desire to get back into the game. If bonds are to be bought, it is up to the EFSF and its successor, the European Stability Mechanism (ESM), to step into the market.

Nice idea, but a few wrinkles would have to be ironed out. The first is the bond-buying restrictions on the EFSF. Yes, the fund can buy bonds, but only as part of a full-blown sovereign bail-out package, that is, it could buy Greek, Portuguese or Irish bonds, but not Italian or Spanish ones because the latter two countries have not been bailed out (though Spain is nabbing €100-billion to fix its banks).

To buy Italian and Spanish bonds, which is clearly what Mr. Monti and his Spanish counterpart Mariano Rajoy want, the EFSF would have to be granted permission to buy the bonds of non-bailed out countries, and that would happen only if Germany approves the idea, which is no sure thing. German chancellor Angela Merkel may like Mr. Monti a lot more than Mr. Berlusconi, but she still worships at the altar of endless austerity and might see EFSF bond buying as a phony financial fix that would remove Italy's incentive to clean up its act all by itself.

Then another decision would have to be made: Would the EFSF buy bonds in the primary market (that is, at the auction itself), or in the secondary market (from investors). While there are arguments for both, buying at bond auctions has obvious attractions. The EFSF money would go directly to the government, not to bond investors who made the lousy decision of buying the clapped-out bonds in the first place.

But Mr. Monti should not assume his EFSF dream will be fulfilled any time soon. In the short-term, he needs a credible reform and growth package to keep the economic data from deteriorating. He is under enormous pressure to produce one in the next few days.

Mr. Monti is a technical prime minister, that is, he was not elected. His mandate finishes in less than a year. That's not a lot of time to fix Italy, where a crises are typically dealt with in decades or centuries, not months. The question is whether the man will, in effect, give up or give it everything he's got. In essence, does he want to leave the prime minister's office as a hero or the guy who simply passed Europe's biggest nightmare in the making to the next government?