Bonds. Italian Bonds. And Why The World is Watching Them.

Germany, France, Italy - Debt Crisis From left: German Chancellor Angela Merkel, France’s President Nicolas Sarkozy, and Italy’s Prime Minister Mario Monti These days, the ongoing European debt crisis has more twists and turns than a plate of spaghetti.

Several countries—Ireland, Portugal, Greece—have required financial bailouts, funded in part by the European Union. Now nervous eyes are trained on a far bigger player: Italy.

The Problem: Italy, the Eurozone’s third largest economy, has growing debts—$2.6 trillion and counting—and a shrinking economy. Fears are mounting that Italy’s debts may become too much for it to repay.

That’s got everyone watching Italy’s bond market. One way Italy (like the U.S. and its European peers) raises money is by selling bonds. But as Italy struggles, those bonds are looking riskier than ever. Higher risk means higher interest rates that Italy must pay.

The Catch-22? Rates may go so high that Italy can no longer afford to pay them. Right now they’re on the razor’s edge of affordability.

The solution: Italy’s recently-elected prime minister Mario Monti (a former economist) is looking to cut costs, increase tax revenue and grow the economy.

But if that doesn’t work: Italy could need a bailout. If so, it’s not certain where the money would come from. Hence the worry that not only is Italy too big to fail—it may also be too big to bail.

Investors fret that should Italy drown in debt, other larger and more-financially stable countries—most notably Germany and France—will be dragged down in a rescue effort.

Still, an Italian default would be a global economic catastrophe, so some sort of stopgap solution is likely.

Mamma mia…

It’s a small world: Should the rest of Europe, Asia and the U.S. rescue Italy? Photo Source: AP Photo/Michel Euler, Pool

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