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If there were background music for the drama unfolding in Europe right now, it would be Mozart’s opera Don Giovanni. And Silvio Berlusconi, Italy’s soon-to-be-former Prime Minister, would play the lead role. During his 18 years in politics, Berlusconi – a onetime cruise-ship crooner whose politicai troubles have delayed the release of his album of love songs – has faced more than 50 no-confidence votes, dozens of allegations involving everything from tax evasion to Mafia ties to drugs and, of course, numerous sex scandals. His exploits on that score, from a relationship with an underage Moroccan belly dancer to the "bunga bunga" orgies with prostitutes held at his Milan estate, constitute an aria of excess (much like "Madamina, il catalogo è questo," the one Leporello sings in Don Giovanni citing his master’s many conquests). Like Giovanni, Berlusconi is both comic and tragic and refuses to repent, even after wreaking havoc on the lives of everyone around him.
Those are program notes in Italy, where Don Berlusconi has promised to step down from his position as head of what has become the world’s most dangerous economy. The European debt crisis, which has been building for months, has finally reached an apex, escaping the Aegean periphery – where European leaders hoped to pen it in – and engulfing the core of the continent, with potentially terrifying ripple effects around the world.
That’s a crucial fact that’s been lost in all the coverage of the crisis, most of which has been devoted to Greece. While Europe can bail out Greece, it can’t easily rescue a $2 trillion economy like Italy’s. The European stability fund isn’t big enough, even if leveraged to increase its firepower. The International Monetary Fund can’t save Italy either; the IMF was set up to help small emerging markets, not large European nations. And the European Central Bank, stymied by European fears of hyperinflation, can’t play the role of lender of last resort, which is one of the many reasons that Italian borrowing costs have skyrock-eted to euro-era record highs, pushing the country dangerously dose to default.
If Italy goes under, would it be as big a crash as Lehman Brothers’? "Bigger," says Mohamed El-Erian, the CEO of Pimco, the world’s largest bond trader, and a man not given to overstatement. "Italy is the world’s third largest bond issuer, a founding member of the European project and a major player on the world stage. A default must at all costs be avoided ifthe global economy is to avoid a major disruption." In short, Italy is too big to fail. The problem is there’s no Hank Paulson riding to the rescue.
It may be too late anyway. Berlusconi pledged to step down when the Italian Parliament passes a key budget bill that includes provisions for major reforms such as cutting back the country’s civil service, dismantling a lopsided labor market that ensconces older workers in cushy state jobs while youth unemployment soars and boosting the retirement age. All of this is necessary – but may be too little, too late.
But trimming la dolce vita isn’t easy. Those are exactiy the kinds of measures that have been so painfui and disruptive in Greece, where Street protests against austerity rage on after Greek Prime Minister George Papandreou flip-flopped on a decision to hold a referendum on the terms of the latesi European bailout package. Had the public voted against the package, Greece would have defaulted on its sovereign debt. Greece’s new government will push the legislation through and get its next tranche of money. But the fiasco represented the crossing of an important line in Europe. Papandreou’s intransigence forced leaders like French President Nicolas Sarkozy and German Chancellor Angela Merkel to talk publicly about the possibility of a country’s leaving the euro zone.
The Real Rubicon
But the truth is that the world was always going to be able to cope with a Greek default or even a Greek exit from the euro. The real Rubicon lies in Italy. And Italy’s problems are of an entirely different scale.
Both Greece and Italy have corrupt and dysfunctional politics; both are addicted to tax evasion. (Italy’s black market is probably a fifth of its $2 trillion economy, second only to Greece’s 25% of GDP.) But their differences are much more important. Greece’s $311 billion economy pales next to Italy’s, the third largest in the euro zone. Greek stock markets are minuscule; Italy’s biggest companies – multinationais such as Fiat and ENI – are very likely held by your pension fund or in your 40I(k).
Most important, American banks either own or are exposed to a good chunk of Italian debt, which is why they have begun hedging against the risk of default. The Bank of Italy’s latest Financial Stability Report, published this month, showed that American banks have started purchasing extra protection on Italian debt. The banks and other investors have also started severely tightening their lending to European banks and to companies with significant European exposure. MF Global, the trading house run by former Goldman Sachs GEO Jon Corzine, collapsed under the weight of its large, highiy leveraged positions in European bonds. "The demise of MF Global has shown that the financial links between Europe and the U.S. are important," says Paul Dales, senior U.S. economist for Capitai Economics. "They know they are not immune to the events in Europe."
It’s telling that American financial institutions are more worried now about hedging European risk than they have been in the two years that Greece has been sliding toward default. It’s ironie, because Italy’s public finances aren’t the worst in Europe. While Greece’s debt-to-GDP ratio is about 160%, Italy’s is 120%, which is just about manageable. By comparison, the U.S.’s is about 100%. The problem is that Italy’s borrowing rates are going up by the day, meaning investors think default is becoming more likely. That’s an almost self-fulfilling prophecy, since higher borrowing fees make the debt-servicing costs much worse, which in turn makes credit dry up, which in-creases the risk of default. Perhaps the scariest thing in that scenario is the parallel to the Lehman Brothers crash, in which a credit crunch also spiraled out of control.
The European Divide
One thing that could help calm markets would be an orderly transition to a more competent government in Italy. Then again, Italy does not do orderly. Since the euro crisis reached a fever pitch this past summer, Berlusconi has beer, either fighting offscandais (including allegedly paying off a couple who claimed to have provided him with prostitutes) or trying to stave off reforms that would hurt his enormous Fininvest media empire (which has a monopolistic lock on Italian television). That hasn’t inspired much market confidence.
While Berlusconi didn’t cause Italy’s problems, his inept leadership certainly made them worse. One ofhis government’s many outrageous suggestions for improving the economy over the years has been to offer amnesty to Italians willing to repatriate illegally acquired assets. Perhaps more than any other single character, he represents the huge divide separating the actors trying to bridge the two halves of Europe – profligate southern countries like Greece and Italy, and nose-to-the-grindstone eco nomic powerhouses like Germany and, by comparison with Italy, even France.
While Germans have spent a decade making the sorts of painfui reforms that have tumed them into the model for how to run a rich nation, Greece and Italy have used the privileged borrowing position they enjoy as members of the euro zone to avoid the hard work of cleaning up their economies. High taxes have scared away business, and mass tax evasion means that public coffers frequently go empty. Corruption, a bloated and inefficient state sector and the huge black-market economy have discouraged business and kept private-sector unemployment high. As Standard & Poor’s said earlier this fall when it downgraded Italy’s credit, the country’s debt problems couid be fixed were it not for entrenched interests including politicians, incumbent monopolies, public-sector workers and unions, which "impede the government’s ability to respond decisively to challenging economie conditions."
Casa di Cards
The fall of Berlusconi and the reshuffling of chairs in the Greek government underscore the nearly impossible task ahead for European leaders: balancing austerity and growth while also staying in office. Even in less dysfunctional nations like France and Germany, it’s a tough act. Reforms ofthe’k.ind so desperately needed in Europe right now tend to work best when countries are coming out of recession, not going into it. That’s led most economists to conclude that Europe is headed for a double-dip recession. Retail sales across the continent are plunging, and GDP growth, negligible this quarter, will probably contract by year-end. Even Germany, the strongest nation in Europe, is hurting. Industriai production in Europe’s export powerhouse is falling as its neighbors and major trading partners batten down the hatches.
Will Europe pulì the U.S. into recession too? As ever, it ali depends on the banks. The trade links between the U.S. and Europe alone won’t have a decisive impact. The U.S. sends just 13% ofits exports to the euro zone and much less to the economies in the most trouble. But if Italy defaults, it would likely set off another global financial crisis that could tank the world economy. More than three years after the failure of Lehman Brothers, we don’t seem to have come very far.
That’s one reason that flush emerging markets like China have been so reluctant to help baii out Europe. The West isn’t just rife with debt; it also has a trust deficit. Banks on either side of the Atlantic still aren’t working properiy. The latesi "comprehensive solution" to the European debt crisis presented in Brusseis last month has turned out to be neither a comprehensive nor even a piecemeal solution. There is political gridiock on both sides ofthe Atlantic. Markets are as roiled as they’ve ever been. Earlier this month, European leaders arrived at the G-20 meeting hat in hand to ask rich developing nations to baii out the West. But they left with no firm commitments, and who couid blame emerging-market nations for not wanting to invest? After all, the best analysis Don Berlusconi couid offer ofhis country’s economie prospects was "The restaurants are full."
And now the bill has arrived. In Italy, a new government may soon have the unlucky task of trying to reform the country’s tax system and restructure its broken economy (though there’s aiways a chance Berlusconi will tryto stand for office again in the new year; don’t count him out till the fat lady sings). But even if reforms began tomorrow, many economists say a lost decade ofslow growth is a foregone conclusion. The likely outcome for Europe as a whole – a slow slide back into recession, the eventual breakup ofthe secondiargest global reserve currency and a continued loss of faith in the ability of Western leaders and Western solutions – isn’t pretty. But they are befitting of opera, where so often the main characters don’t make it to the end of the show.

RANA FOROOHAR