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As we just heard, Italy's economic problems have been mounting steadily. Its borrowing costs have soared in recent days with investors increasingly fearing the worst: default.

NPR's Jim Zarroli looks back now at how conditions grew so dire for Italy.

JIM ZARROLI, BYLINE: On the face of it, Italy is an economy that has plenty of strengths. It's the third biggest economy in the eurozone. It has a strong manufacturing base and it exports a lot. Marco Simoni is a lecturer at the London School of Economics.

MARCO SIMONI: The bottom line is that Italy is very far from having a Greece type of problem or a Greece type of situation. It's a solid country with a lot of resources.

ZARROLI: And yet, right now, economists have grown increasingly worried that Italy's troubles could drag down the entire European economy. Italy owes a lot of money. Its total debt is equal to about 120 percent of its gross domestic product. Simoni says much of Italy's debt stretches back to the 1980s when the government went on something of a spending binge.

The country has made periodic efforts to pay off its debts, but it's been hamstrung by a weak economy. Simoni says Italy's notorious bureaucracy makes doing business there difficult.

SIMONI: It's not only the taxes are high, but they are too high in business, so they penalize economic growth rather than supporting it.

ZARROLI: And Simoni says a lot of vested interests in Italy benefit from the system and the Berlusconi government has simply been unwilling to take them on.

SIMONI: The number of reforms that the government has done in the last year, 12 months, real reforms in terms of like changing the structure of something is one from the university system last December.

ZARROLI: Today, Italy's growth rate has slowed to a crawl and Alessandro Giansanti, a senior rate strategist at ING Bank, says the economy could contract two or three percent next year.

ALESSANDRO GIANSANTI: The market now is expecting a double dip in the Euro area and the Italian economy - that's the market that will suffer most.

ZARROLI: As investors have lost confidence in the Italian government, the interest rate it must pay to borrow has been steadily rising. Gabriel Stein of Lombard Street Research in London says that, as interest rates rise, Italy will have to begin doing something that can only exacerbate its growth problems: It will have to cut government spending.

GABRIEL STEIN: If they do not, you enter a vicious circle called a debt trap where the debt simply rises without limit and the cost of servicing the debt rises without limit and, of course, that is a very, very rapidly unsustainable position.

ZARROLI: With the cost of borrowing on the rise, more and more investors are starting to worry about Italy's ability to pay its debts. By one estimate, if interest rates rise to nearly eight percent, Italy will have to spend 20 percent of its revenue just servicing its debt.

And as conditions tighten, the specter of a default looms larger. About half of Italy's debt is held by Italians themselves, people and institutions that bought government bonds as an investment. But the other half is held by foreigners, especially by big European banks. Marco Simoni says a default by Italy would quickly spread throughout the financial system.

SIMONI: We are very far from it, fortunately, but it's something that would put at risk major banks in Europe, therefore endangering the entire European economy, therefore endangering even the American economy.

ZARROLI: The announcement today that Prime Minister Berlusconi will step down gave a temporary boost to the financial markets. Many investors have come to see the Italian leader as an impediment to reform. But Italy has entrenched problems, problems that Europe will have to address if it hopes to truly contain the crisis.

Jim Zarroli, NPR News.

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