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Why Everyone Is Suddenly So Worried About Italy

Over the past few days, investors suddenly got very worried about Italy. The interest rate on Italian government bonds shot up to a euro-era record, and shares in big Italian banks fell sharply.

Italy's economy is the third biggest in the euro zone. It's much bigger than Spain's economy — and Spain is the country that everybody's been worried about, the country that's too big for the rest of Europe to rescue.

If Italy were to get into serious fiscal trouble, the shocks would reverberate through Europe and the U.S.

As today's NYT notes:

European banks have total claims and potential exposures of 998.7 billion euros to Italy, more than six times the 162.4 billion euro exposure they have to Greece, according to Barclays Capital. ...

In the United States, banks are also more exposed to Italy than to any other euro zone country, to the tune of 269 billion euros, according to Barclays.

Italy's annual deficits are relatively small. There was no crazy housing bubble there, and Italian banks are in decent shape.

But — and this is a big but — Italy's debt is huge compared to the country's overall economy. Its debt to GDP ratio of 119 percent is the second highest in the euro zone, after Greece.

Late last week, Silvio Berlusoni publicly attacked the country's finance minister, who has been pushing for budget cuts. In the context of everybody already being nervous about Europe's debt troubles, that was enough to set yields soaring on Italian sovereign bonds.

Rising yields can have a self-reinforcing effect: A government has to make higher interest payments on its debts, which in turn drives it further into debt. This leads investors to lose confidence, and demand still higher interest rates.

There may be time yet for Italy to avoid this kind of spiral. Yields on Italian bonds fell today after Berlusconi said he would push to speed up the country's next round of budget cuts.

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