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Italian Prime Minister Silvio Berlusconi, shown at Rome's Chigi Palace in August, leads a country that has become the new epicentre of the European debt crisis.


The surprise scrapping of the Greek referendum delivered a rare victory to euro zone leaders, but a fresh crisis has erupted in debt-swamped Italy, an economic giant whose collapse would make Greece's woes look like a minor headache.

The U-turn put smiles on the faces of investors and G20 leaders, but when they turned their attention to Italy and Prime Minister Silvio Berlusconi, their grins vanished. Even though the Greek government could still implode, piling a political crisis on top of a debt crisis, Italy is emerging as the greater problem, a potential bunker buster in comparison to the Greek grenade. There is no doubt that Italy has emerged as the new epicentre of the two-year-old debt crisis.

At a press conference Thursday evening at the Group of 20 summit in Cannes, Italy had the dubious honour of playing a starring role in French President Nicolas Sarkozy's comments. In classic diplomatic argot, he praised Italy's "entrepreneurial tradition," then hinted that its economic reform efforts, or lack thereof, were becoming a worry. "And that's where we need to work a little bit more," he said.

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Translation: Italy had better get its economic house in order, subito.

The roller-coaster ride of Italy's aging Lothario prime minister has been as jarring as that of Greece's George Papandreou. Mr. Berlusconi arrived at the two-day G20 summit Thursday as Italian sovereign bonds traded at crisis levels – investors evidently taking the view that Italy, the euro zone's third-biggest economy, could be Greece multiplied by 10.

The yield, or interest rate demanded by investors, on benchmark Italian 10-year bonds soared to 6.4 per cent at one point. That was the highest yield since 1997, when Italy was in recession. While it fell to 6.18 per cent later in the day, it remained firmly in crisis territory.

For any country, yields of about 6 per cent are reliable crisis signs. Greece, Ireland and Portugal each required bailouts (sponsored by the European Union and the International Monetary Fund) within months of their sovereign bond yields reaching 7 per cent, a level that is considered unsustainable.

Meanwhile, back in Rome, the knives were out for Mr. Berlusconi, as confidence in his ability to prevent the Greek debt crisis from infecting Italy all but vanished. "The financial crisis is real and the issue of confidence vital for Italy and Europe," said James Walston, a political commentator and professor at the American University of Rome. "Berlusconi is fighting for his political life."

In a front-page editorial on Thursday, Il Sole 24 Ore, Italy's leading financial daily, said the Prime Minister was going "to Cannes empty-handed." The paper noted that he had agreed the night before on a mere "mini-plan" – dominated by promises to sell state property and provide some job stimulus – to fight the crisis rather than the full-bore reform package that economists and EU leaders think is required to lift the country out of its long slump.

On Wednesday, six former allies of Mr. Berlusconi urged him to hit the road after his government failed to introduce bold economic reforms. They wrote an open letter calling for a "new political phase and a new government," one that would put reforms in place.

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Pressure is mounting on Mr. Berlusconi, who has won three elections since the 1990s, to step down and make way for a technical government, one that would carry out tough economic and financial reforms without fear of the popular backlash that could trigger an election.

On Wednesday, Giorgio Napolitano, Italy's essentially powerless but highly respected President, held meetings with lawmakers from all parties to determine if Mr. Berlusconi had enough support to launch strong reform packages. Mr. Napolitano himself has been calling for such measures. "And whereas old crises could play on for weeks or months, Belgium-style, and the country continued steadily, this one is for real and at stake is the economic future of the country," Mr. Walston said.

How did Italy become part of the euro zone's problem so quickly?

By many measures, the Italian economy and state finances are in decent shape, probably no worse than Britain's or Spain's. Italy's budget deficit, as a percentage of gross domestic product (or total economic output), is one of the lowest in the euro zone – an estimated 4 per cent this year, falling to 2.2 per cent next year. (Britain's deficit this year will be 8.2 per cent, France's 5.9 per cent.) Italians are savers, and mortgages are rare, meaning private debt loads are small by Europe's spend-more-than-you-earn standards.

The problem is that the Italian government's debt load is enormous and potentially crushing as its bond yields rise, making debt servicing charges more expensive. At 120 per cent of GDP, it is the second-largest in Europe, after Greece's, the result of decades of spending too much and inefficiently.

The other problem is a stagnant economy. Relative debt loads fall when the denominator – GDP – in the debt-to-GPD ratio rises. Italy's GDP is going nowhere, thanks to a bloated and inefficient civil service, a bizarre and deadening tangle of business regulations (Italy is routinely touted as one of the hardest countries in the world in which to start a business), high taxes, corruption, strike-prone unions, a fractious government that seems incapable of uniting in the face of economic danger and protected professions. "Italy's growth engine is broken," economists at the French bank Société Générale said in a recent report.

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And a recession is coming in Europe, which will punish Italy's already ailing, export-led economy. Almost every economic forecast puts Italy in recession in 2012. Layer on Mr. Berlusconi's endless sex scandals, corruption court cases and the public's sense that he would rather host "bunga bunga" parties than fix the economy, and you have a recipe for a full-blown debt crisis.

No wonder the EU is obsessed with delivering more firepower to the bailout fund, known as the European Financial Stability Facility. Equipped with €440-billion of borrowing power, it is clearly too small to rescue a country €1.7-trillion in debt. With Italy in mind, efforts are being made to give the fund €1-trillion or more.

Pressure on Mr. Berlusconi to step down has become relentless in recent days. Next week will be crucial for his leadership and the economic future of the country. The rebels within his party are threatening to oppose him in a vote to sign off on the 2012 budget. "We're asking Berlusconi to give us a signal," said Isabella Bertolini, one of his dissenters. "Whether it's a reshuffle, a new government or a new premier is up to him to decide."

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