NEW YORK (
) -- Italy is too big to fail, and a possible credit crisis could push the European monetary union to the brink, according to industry watchers.
Unlike the Greek financial crisis, which has often been compared to the 2008 collapse of Lehman Brothers in the U.S., Italy is too big for the market to absorb a default or bailout without major losses.
That means European banks and policymakers will need to find another solution, perhaps as big as the multibillion-dollar bailout of
"Italy is an insular fiscal crisis that could easily turn into a financial crisis very quickly," says Adolfo Laurenti, deputy chief economist for Mesirow Financial in Chicago.
Italian bond yields hit new highs today as the focus of the European debt crisis zeroed in on the perceived weakness of the eurozone's third largest economy.
The yield on the Italian 10-year bond reached 5.72% by early afternoon, the highest since the creation of the euro, amid fears that political disagreement over how to tackle the country's huge national debt may drag Italy into the fray.
The cost of insuring against an Italian default is also on the rise, with the cost of a five-year credit default swap currently trading at 250 basis point above sovereign spreads.
European leaders have some breathing room. The fallout from a sovereign debt crisis in Italy can be momentarily contained because much of the government's debt is held by Italian households and not foreign investors, explains Laurenti.
"Italy is in a better position when compared to Spain or Portugal, because pressure from foreign investors is not as great," Laurenti says. "But the debt is very large when compared to other countries; nearly $1 trillion euros. So if this crisis continues, it could be a game-changer for Europe."
Standard and Poor's downgraded the outlook for Italy to negative from stable in May and maintained that position in its most recent report of July 1. The ratings agency cited Italy's weak economic growth and the prospect of extended political gridlock, which S&P's analysts say "could contribute to fiscal slippage."
But the crisis hit a crescendo last week. Prime Minister Silvio Berlusconi criticized Finance Minister Giulio Tremonti's handling of Italy's proposed austerity package, heightening fears that attempts to rein in the country's 119% debt-to-GDP ratio may be derailed.
Italy's economy has been growing at less than 1% for some time.
European finance ministers arriving in Brussels ahead of a meeting about the problem of Greek debt attempted to reassure the markets that Italy is stable. German Finance Minister Wolfgang Schaeuble described Italy's $56 billion austerity plan to balance its budget in 2014 as "very convincing," while Spanish Finance Minister Elena Salgado insisted, "Italy can get out of this situation on its own."
But for Laurenti, relatively healthy economies like Germany and France do not have the ability to bail out the Italian state on their own.
"What can be done for Greece, Spain or Portugal cannot be done for Italy," Laurenti says.
Laurenti remains skeptical that even an Italian default could ultimately lead to a breakup of the European monetary union because the cost of scrapping the common currency is greater that cobbling together a fragile solution.
"All financial contracts are written in euros, so there would be significant increase in cost in converting to another currency." Laurenti says. "Also, the conversion would need to take place immediately to have any chance of making a difference. People don't have three months. They will have three days. And that is not practicable."