14 November 2011 Last updated at 11:21 ET

What's the matter with Italy?

By Laurence Knight Business reporter, BBC News

Italy has moved to centre stage in the eurozone debt crisis.

While Greece generated a lot of noise, it is now seen as a sideshow.

Greece's debt problems are already widely known and the immediate consequences of a Greek default largely anticipated.

Moreover, the size of the Greek economy is small enough that the direct damage, if Greece stopped paying its debts, should be quite manageable for the eurozone.

Instead, the big fear is "contagion" - that a Greek default could trigger a financial catastrophe for other, much bigger economies - in particular Italy and Spain.

That is why European leaders announced in October a significant expansion of its bailout fund, the European Financial and Stability Facility (EFSF).

And it seems it is Italy that is now seen as the lead candidate for that contagion among Europe's big economies and the main possible beneficiary of the enhanced bailout fund.

Why is that?

Prudent Italy?

According to Germany's Chancellor, Angela Merkel, "Italy has great economic strength, but Italy does also have a very high level of debt and that has to be reduced in a credible way in the years ahead."

As with Greece, she and other eurozone leaders believe the solution is more government austerity - spending cuts and tax rises - by Rome.

However, some economists might disagree with her assessment.

The Italian government's debt, at 118% of GDP (annual economic output) is certainly high, even by European standards.

But dig a little deeper, and the picture changes.

Unlike their counterparts in Spain or the Irish Republic, ordinary Italians have not run up huge mortgages, and generally have very little debt.

That means that according to the Bank of International Settlements Italy as a country - not just a government - is not actually terribly indebted compared with other big economies such as France, Canada or the UK.

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Moreover, the large debts of the Italian government are nothing new. It has got by just fine with a debt ratio over 100% of its GDP ever since 1991.

The main reason is because - unlike Greece - Italy is actually quite financially prudent.

The government spends less on providing public services and benefits to its people than it earns in taxes, and has been doing so every year since 1992, except for the recession year of 2009.

Indeed, the only reason Italy continues to borrow at all is to meet the principal and interest payments on its existing debts.

Grim outlook

So why is Italy in trouble now?

The reason is because its economy is so weak.

Italy is plagued by poor regulation, vested business interests, an ageing population, and weak investment, all of which have conspired to limit the country's ability to increase production.

The country has averaged an abysmal 0.75% annual economic growth rate over the past 15 years.

That is much lower than the rate of interest it pays on its debts.

And this creates a risk that the government's debtload could grow more quickly than the Italian economy's capacity to support it.

In the past, this risk has not materialised, thanks to Italy's relatively high inflation rate, which has steadily pushed up the government's tax revenues.

But now the outlook is much more grim.

Self-fulfilling prophecy

Like other southern European economies, Italian wage levels rose too quickly during the good years, and left Italy uncompetitive versus Germany and other northern economies within the eurozone.

That lack of competitiveness is likely to mean many years of even weaker growth and low inflation, as Italian workers find their pay is frozen, or even cut, until they regain a price advantage over German workers.

But lower growth and inflation suddenly make the Italian government's debt load look much less sustainable.

Further government spending cuts are likely to hurt the economy even more, and - as Greece is discovering - may not even do much to improve the government's borrowing needs if they lead to a sharp rise in unemployment.

That scary outlook has freaked out markets, and lenders are demanding a much higher interest rate from Italy in order to lend it the new money it needs to repay its old debts as they come due.

To borrow money for 10 years, Italy now has to pay an interest rate of 6.7%. Germany, by contrast, must pay only 1.8%. Spain - Europe's other big, troubled economy - must pay a record 6.1%.

But of course this higher cost of borrowing makes Italy's debts look even less sustainable.

That means the market's loss of confidence in Italy could well end up becoming a self-fulfilling prophecy.

If nobody will lend to Italy, then Italy cannot repay its debts. And if Italy cannot repay its debts, then nobody will lend to it.

And if markets do panic and switch their money out of Italian debt into "safe" German debt, Italy would need an enormous bailout that would dwarf the original 440bn-euro EFSF, agreed in July.

Much of this fund had already been earmarked to support Greek government spending.

Insurance

The new deal is designed to prevent this scenario.

European leaders have agreed to expand the EFSF to, in effect, insure lending to countries such as Italy up to a value of about 1tn euros - more than double what was available before.

The hope is that this will also reduce the cost of Italy's borrowing and so make it easier for the country to pay back its debts without drawing on the facility's insurance.

But the deal comes with caveats - Italy is expected to implement a new round of austerity measures to ensure its debts stay under control.

It is not clear that the coalition government - now led by the technocratic former EU Commissioner Mario Monti - is able to implement further cuts.

Furthermore, if the economy then fails to grow - as happened in Greece - and Italy looks even less able to pay back its debts, investors may ask who will ultimately pay for insuring them.

October's deal did not go into details on how the expansion of the lending facility would ultimately be funded.

And even if it does get funded, it may still not be enough to rescue both Italy and Spain.