Will Italy Bring Down the Eurozone?

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Francois Lenoir / Reuters

Forget Greece. The biggest question mark in the never-ending eurozone debacle is now Italy.

European markets have been getting slammed over fears that Italy may be the next domino to fall. But why is Italy — whose debt problems have until now been on the back-burner — suddenly feeling the heat? First, eurozone finance ministers have been humming and hawing about whether they’re going to throw more money in the rescue pot for flailing economies like Italy. That’s making investors in eurozone debt worry that no one will be there to pick up the slack when these strung-out economies finally flop. Yields on Italy’s 10-year bonds have been hitting just below 7%. Above 7% , bond investors typically start to fall off, which makes it even harder and more expensive for Italy to borrow and keep its wheels spinning. As was the case in Greece and Portugal, hitting the 7% mark could set Italy on the path to default.

The eurozone crew also can’t figure out what to do about Greece, and that’s making things look worse for Italy. Eurozone bosses Germany and France were hoping to rope banks into Greece’s pending second bailout. But that means the banks would have to take a big loss on what they’ve already lent Greece, and, just like everyone else in this game, they’re not that willing to pay. The credit raters eying Greece’s debt problems have also poo-pooed the plan. As I discussed on the blog last week, raters like S&P think  banks ‘voluntarily’ rolling over Greece’s debt is just a dressed-up version of default. With that option in jeopardy, European leaders have moved on to the idea of letting Greece default temporarily while they work on getting banks to cooperate. But the idea of even a temporary Greek default is making countries like Italy and Spain even more fearful about financial contagion (meaning if Greece defaults, investors start hammering their bond markets too). And, oh yeah, Italian banks — several of which are top holders of Greek debt — might also just collapse.

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Add to that political infighting between Italian politicians over the country’s pending budget cuts, and the risk factors in Italy seem sky-high. Failure to pass Italy’s latest round of austerity measures, which are slated for a vote this week, would give lenders one more reason to flee.

So how will it all play out? There are a lot off balls still up in the air, but a few things are clear. First, Italy is the third-largest economy in the eurozone and a much bigger player than Greece or Portugal. If lenders retreat, European officials will have a much harder time coming to Italy’s rescue. And the situation doesn’t even have to be that dire for Italy (and the eurozone) to implode. Italy’s debt, at 120% of GDP, is already higher than the levels at which Greece, Portugal, and Ireland reached out for help. Italy’s growth is appallingly sluggish and its labor market and pensions plans are in desperate need of reform. As noted recently in the Economist: “Between 2000 and 2010 Italy’s average growth, measured by GDP at constant prices, was just 0.25% a year. Of all the countries in the world, only Haiti and Zimbabwe did worse.” The fact that much of Italy’s debt is held at home would typically be a good sign. But as its budget woes drag on and investors continue to pull back, there’s no telling how long Italian investors will be able to fill in the widening budget gap.

It all adds up to a lose-lose situation for Italy, and the eurozone overall. Big reforms to Italy’s labor market, where workers are under-productive and over-paid, are in the short-term bound to slow down already stagnant growth. But without those reforms, investors are bound to flee. Either way, the drop-off in public revenues means Europe’s bailout tab is destined to continue expanding. The question is who (banks or taxpayers) will get stuck footing the bill.

Roya Wolverson writes for TIME. Find her on Twitter at @royaclare. You can also continue the discussion on TIME’s Facebook page and on Twitter at @TIME.