Euro Fears Spread to Italy as the Debt Crisis Deepens

A trader on the floor of the New York Stock Exchange on Wednesday, when stocks plunged over fears about Italy's debt.

PARIS — Since the start of the euro crisis two years ago, the big fear has been contagion, that market unease about the high debt and slow growth in Europe’s southern rim would infect the core. On Wednesday, contagion arrived with brute force.

Italy, a central member of the euro zone and its third-largest economy, struggled to find a new government as anxious investors drove Italian bond rates well above 7 percent and the markets tumbled worldwide. And although critics have warned of just such an escalation for months, European leaders again were caught without a convincing response.

Unappeased by the imminent resignation of Prime Minister Silvio Berlusconi, investors appeared to have focused on the political gridlock in Italy that seemed likely to follow his departure from office, and the unenviable task awaiting a successor: restoring growth in a country that has seen almost none in a decade, and financing $2.57 trillion in debt. Italy, unlike Greece, is seen as too big to default and too big for Europe to bail out.

Only days after the Group of 20 meeting in Cannes, France, where President Obama and other world leaders urged European officials to take bolder action, they appeared frozen in past positions. The German chancellor, Angela Merkel, met with her kitchen cabinet of economic “wise ones.” They proposed the creation of a $3.1 trillion debt repayment fund that would pool and jointly finance debts of all 17 members of the euro zone in return for some conditions like legal debt limits and collateral.

But Mrs. Merkel effectively dismissed the idea, saying that it could be studied and would in any case require major treaty changes, which would take time. She instead emphasized that deep economic changes were required in some member states and that Europe needed to restore fiscal discipline.

“It is time for a breakthrough to a new Europe,” Mrs. Merkel said. “A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can’t survive.”

But the German prescription of austerity is not popular. It is Berlin, citing the very treaties that it now wants to adjust, that has resisted the boldest answer to the euro crisis — using the European Central Bank as the euro zone’s lender of last resort. Berlin does not even want to sanction American-style quantitative easing to promote economic growth, one recipe to stoking growth and reducing the debt burden.

“Contagion is alive and well,” said Rebecca Patterson, chief market strategist at J.P. Morgan Asset Management. Unlike Greece, she said, Italy could pose “systemic” risks to the global economy, accounting for 20 percent of the gross domestic product of the euro zone. “People are wondering if we’ve moved to a new level of the crisis.”

Europe has set up a special bailout fund, the European Financial Stability Facility, but it has taken months to work out the details of how it would be financed and what its role would be, and at any rate it is far too small to cover the debts of a major country like Italy.

European promises to leverage the fund even up to $1.4 trillion have not been fulfilled. Efforts to get other nations to invest in it or in a proposed parallel fund were flatly rejected in Cannes. At most, surplus nations like China and Russia said that they would prefer to deal with an enlarged International Monetary Fund, where at least the rules are clear and there are firmer guarantees that money would be deployed effectively.

The European Central Bank itself appeared flat-footed on Wednesday. It has been buying Italian and Spanish bonds in a special and supposedly temporary program to try to keep down rates to sustainable levels while the bailout fund was allowed to enlarge.

On Tuesday, there was a suggestion that the new head of the bank, Mario Draghi, an Italian, had restricted its purchases of Italian bonds to try to put more pressure on Mr. Berlusconi to quit and on Rome to pass the deep economic reforms he had promised earlier in the summer. If so, the pressure worked. But if the bank was buying a lot of Italian bonds on Wednesday, as some reports suggested, it was overwhelmed by investors who are clearly beginning to wonder if the euro itself is failing.

Markets also seemed panicked by rumors out of Brussels that France and Germany were even discussing the expulsion of some countries from the euro zone, a suggestion quickly denied by French government spokesmen. France and Germany are discussing possible treaty changes that would create more coordinated “economic governance” for countries that use the euro, including more central surveillance of national budgets and their financial estimates, clearer rules and sanctions for those countries that violate them.

Britain and some of the other nine members of the European Union that do not use the euro are opposed to any treaty change, which should be approved by all 27 members. But Germany has suggested that countries using the common currency could adopt new political and fiscal treaties, accepting new rules that could potentially force some weaker countries to choose the difficult and equally uncharted path of leaving the euro.

Even if the euro stabilizes, that kind of treaty move would institutionalize a “two-speed Europe” — of the euro zone and the others — with different rules and conditions, which many members oppose. On Wednesday, Nick Clegg, the pro-European deputy prime minister of Britain, warned the euro zone nations not to create “a club within a club” as they integrate further to try to save the currency. That followed a quiet dinner of the 10 non-euro zone finance ministers in a Brussels hotel, a kind of warning to the others that the non-euro-using members intended to fight jointly for their interests.

It was another example of the way that the euro, which was meant to unite the Continent after the Soviet collapse and promote more federalism, is now pulling the European Union apart, both within the euro zone and between the euro zone and the others.

President Nicolas Sarkozy of France fueled anxiety on Tuesday when he said that the two-speed model for Europe was the only way forward given the prospect of an even larger European Union. “There are 27 of us,” Mr. Sarkozy told French students in Strasbourg. “Clearly, down the line, we will have to include the Balkans. There will be 32, 33, 34 of us. No one thinks that federalism, total integration, will be possible with 33, 34 or 35 states,” he said.

But in a speech delivered Wednesday night in Berlin, the president of the European Commission, José Manuel Barroso, pleaded for unity and called on all member states to join the euro. “A split union will not work,” a written draft said. “That is true for a union with different parts engaged in contradictory objectives; a union with an integrated core but a disengaged periphery; a union dominated by an unhealthy balance of power.”

But the crisis has sidelined Mr. Barroso, and plans for more integration seem almost utopian. In any case, they would take far longer to execute than most market investors want to contemplate.

The confusing Greek government drama — the country has yet to select a new interim prime minister — has already become a sideshow, given the small size of Greece. Investors, perhaps spooked by the 50 percent write-down in the face value of privately held Greek debt, want to hear that Italy is being fully backed and supported by its colleagues and partners. So far, that is a message that Germany, let alone France, is unwilling or unable to deliver.

And of course the fear in Paris is that France will be next. Mr. Sarkozy’s government just announced another set of budget cuts and tax increases in the face of lower growth, to keep to its promises to cut its own budget deficit.

But on Wednesday, the spread of 10-year French government bonds over their German equivalent rose to a euro area high of around 140 basis points. “Contagion” is not just a movie.