This is damned serious. Reading between the lines of statements by Angela Merkel and Nicholas Sarkozy, if quick action isn't taken to fundamentally alter the very idea of the EU and integrated markets and currency, the whole edifice is likely to collapse - sooner rather than later.

Italy's borrowing costs shot past 7% - a level that analysts say is "unsustainable." The danger now is that markets will react to this development and begin a round of short selling Italian bonds. This would drive up costs further, which would lead to more hedging - and the vicious circle would eventually lead to no one wanting to buy Italian bonds because the costs to the government would be so enormous it would be impossible for investors to get their money back.

This is what happened to Greece - a country whose economy is about 10% of Italy's.

Even Berlusconi's promised resignation hasn't calmed the markets.

Reuters:

Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.

Portugal and Ireland were forced to seek EU-IMF bailouts when their borrowing costs reached similar levels and clearing house LCH.Clearnet sounded another alarm by increasing the margin it demands on debt from the euro zone's third largest economy, effectively raising the cost of holding Italian bonds.

The European Central Bank, the only effective bulwark against market attacks, wasted no time intervening to buy Italian bonds in large amounts.

"The ECB is buying aggressively," one trader said.

Italy has replaced Greece at the center of the euro zone debt crisis and is on the cusp of requiring a bailout that Europe cannot afford to give. Unlike Greece, an Italian default would threaten the entire euro project.

Having lost his majority in a key parliamentary vote, Berlusconi confirmed he would resign after implementing urgent economic reforms demanded by the European Union, and said Italy must then hold an election in which he would not stand.

A two tiered euro zone, roughly divided between north and south? Hacking off nations that are in difficulty might be their only option to save what's left. It would be a bloodless revolution, but the consequences would be disastrous for Greece and a few other nations.

The ECB's buying of Italian bonds risks a German backlash. They purchased $80 billion last week alone and the German parliament has made it clear that any such effort by the central bank might result in Germany withdrawing from the EFSF - the bailout fund that the EU is counting on to save member states from default.

Except, as the article notes, Italy is far too large for any conventional bailout. Even the IMF doesn't have access to that kind of cash. So what to do?

I don't think it's a certainty, but if Italy is on the brink of default, watch what the Federal Reserve does here in the US. It's just unthinkable that Italy would be allowed to go down without some kind of international effort to save it. No one is talking about it now, but you can be sure it is in the back of the minds of Merkel, Sarkozy, and whoever will be the next Italian PM.