9 November 2011 Last updated at 13:59 ET

Article written by Robert Peston Business editor

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Eurozone faces an existential crisis

 

Italy is facing the prospect of failing to service its massive debts. It could have potentially disastrous consequences for the rest of Europe.

The eurozone faces an existential crisis following alarming increases in the interest rates that Italy would have to pay to borrow.

The cause is a dramatic slump in the price of every category of Italian government bond. It followed a decision by an organisation called LCH.Clearnet, whose business is making sure that bond deals go through, to demand that traders in Italian bonds put up more cash as a deposit against the risk of those transactions turning bad.

The impact has been to make it more expensive to hold Italian bonds, so the price of those bonds has fallen, and the implied interest rate for the Italian government has soared.

Every single maturity of Italian government bond, from one year up to 30 year, closed at a yield well over 7%.

On any new borrowing, Italy would now have to pay well over 7% and if that rate were applied to its entire 1.8tn euros of debt, well it would cripple Italy's economy, which in turn would make it impossible for Italy to repay its debts.

What that interest rate says is that commercial lenders to Italy are dangerously close to going on strike.

That would be a disaster for a country that has to borrow more than 300bn euros next year just to repay existing debts.

What's the solution?

Well the creation of a stable government in Italy with credible policies for easing the burden of debt would help to reassure investors that lending to Italy would not be throwing good money after bad.

But Italy's political history does not augur well for the establishment of a strong government able to make tough economic decisions.

More important therefore is that the eurozone has to demonstrate that in an emergency it would lend what Italy needs.

Right now the eurozone can't do that. There is too little money in its bailout fund and the institution with the deepest pockets, the European Central Bank, has made it crystal clear that it won't provide enough.

So unless within days, either the European Central Bank changes its mind, or a way can be found to rapidly increase the firepower of the bailout fund, the European Financial Stability Facility, or the International Monetary Fund steps into the breach (or some combination of all three) the risk of an Italian default, which would cause financial mayhem, would become dangerously real.

That will presumably focus minds in Germany. As the biggest and strongest economy in the eurozone, Germany would be at the heart of any Italian rescue. It has so far refused to put any more of its own money at risk in the EFSF or to allow the European Central Bank to become the lender of last resort to financially-stretched governments.

Reason dictates that Germany will put up the necessary money because the alternative, Italy being unable to repay its debts, would cause economic misery in Europe and beyond, and could fracture the eurozone.