Wobbling Domino What Comes Next for Troubled Italy?

Italy appears to be moving toward political stability with reports that respected banker Mario Monti may become the country's next prime minister. But can he succeed in reversing years of political stagnation? If he doesn't, Rome's problems could spell the end of the European currency union.

By and

Italy now holds the keys to the euro crisis.

Italy now holds the keys to the euro crisis.

It was Wednesday, the day after the political fate of Italian Prime Minister Silvio Berlusconi appeared to have been sealed, and people were astonished -- and deeply concerned. Many had felt that the financial markets would cheer the approaching departure of the Italian premier. But they were sadly mistaken. Instead of declining, the interest rates Italy must pay for new sovereign bonds rose sharply on the day after Berlusconi announced he would soon resign. Yields on 10-year bonds were intermittently as high as 7.45 percent. Portugal and Ireland turned to the bailout fund for assistance when their bonds reached that level in 2010.

Even after the announced departure of Il Cavaliere, Italy -- it became clear this week -- remains the biggest threat to the euro zone. The question of whether the currency area will survive hinges on the country, the euro zone's third-largest economy. Italy's debts exceed €1.9 trillion ($2.58 trillion), which is 120 percent of the country's annual economic output. Only in Greece is the debt-to-GDP ratio higher.

Short-term spikes in bond interest rates, of course, are not a huge problem. But should investors continue to demand record returns, the Italian budget will face tremendous burdens. Next year alone, Italy will have to refinance €300 billion in maturing bonds. Furthermore, the Italian economy is also sluggish and expected to grow by only 0.5 percent this year. By comparison, the German economy is expected to end 2011 with 3 percent growth.

Crucial for Survival

Politically, at least, Italy appeared to be working toward a solution on Thursday. Many of the Wednesday market jitters came about due to a lack of faith that Berlusconi would indeed swiftly depart as promised. But throughout Thursday, support grew for respected economist Mario Monti to lead an interim government. Italian President Giorgio Napolitano nominated Monti, a former European competition commissioner, as senator for life on Wednesday and said that far-reaching economic reforms could be passed as early as this weekend. Both moves appeared to pave the way for Monti to step into the premiership sooner rather than later -- a prospect that sent interest rates on Italian bonds plummeting on Thursday.

Still, even if Monti's arrival cheers the markets -- and eliminates the need for new elections, which many feared would delay reforms even further -- Italy's economic and debt problems remain real. Rome's progress toward solving those problems is crucial for the survival of the European common currency.

So what happens next? There are three possible scenarios.


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