While attention all week has been focused on Greece and their political crisis, Italy found itself in deep trouble trying to sell its government bonds.

Spiegel Online:

The renewed focus on Italy comes at the end of a week of euro-zone chaos, kicked off by Greek Prime Minister Giorgios Papandreou's Monday announcement that he was holding a referendum on the recently agreed to EU aid package for his country. Amid massive pressure from Berlin and Paris -- and the markets -- however, Papandreou backed away from those plans on Thursday.

Yet even as the turmoil in Athens dominated headlines this week, there were increasingly distressing indications that Rome may also be in trouble. For one, Italian borrowing costs soared earlier this week, with interest rates on sovereign bonds rising to 6.4 percent, perilously close to the mark which triggered emergency Italian bond purchases by the European Central Bank in August. Analysts consider a rate of 7 percent to be the level at which investors stop buying sovereign bonds.

Equally concerning are indications that the Berlusconi government may be close to collapsing. Several former Berlusconi loyalists published an open letter in the Italian daily Corriere della Sera on Thursday calling for a change at the top. One of the parliamentarians indicated that a rebellion could be mounted as early as next week, during a budgetary vote on Tuesday. Reuters reported on Thursday that Berlusconi told European leaders in Cannes that he would call a confidence vote within two weeks. The Italian prime minister has survived 53 votes of confidence since 2008, the last of which took place on Oct. 14.

Eroding Support for Berlusconi

The brewing crisis in Rome is of particular concern to European Union leaders. The Italian economy is the third largest in the 27-member bloc and the current euro backstop fund, the European Financial Stability Facility (EFSF), would be insufficient were Italy to run into problems similar to those in Greece. Furthermore, the country is sitting on a mountain of debt worth 120 percent of its gross domestic product. Efforts to implement austerity measures, despite the recent passage of €54 billion in belt-tightening measures, have been spotty at best -- partially due to eroding support for Berlusconi from within his own governing coalition.

The political crisis in Italy has been feeding off the debt crisis and vice versa. The two are inexorably tied together which is very bad news given the instability of government and politics at this time.

French banks have been reducing their exposure to Italian debt but it's problematic whether they will be able to shed enough bad paper before some kind of crisis hits. That's because the political crisis is apt to drive up borrowing costs even further. Italy may become a victim of Sudden Sovereign Default Syndrome if the political crisis is prolonged and if the combined efforts of the EFSF, the central bank, and the IMF can't stabilize the Italian bond market.

While not a likely scenario, who can predict what's going to happen in the next few months? We've seen extraordinary gyrations in the markets as hope turns to despair, which then turns to hope again. We've seen two different Greek bailout plans, trouble in the bond markets of two of the largest economies in Europe in Spain and Italy, and the growing sense among political leaders that nothing they have done has helped resolve the crisis.

The only thing we have to go on is that so far, the euro zone has managed to muddle through. How long they can keep that up is anyone's guess.