Rome / Berlin: Political and economic crisis in Italy spurred fears of a split in the euro zone with borrowing costs for Europe’s third biggest economy near unsustainable levels and the bloc unable to afford a bailout.

The escalating crisis prompted European Commission president Jose Manuel Barroso to issue a stern warning of the dangers of splitting the zone. European Union (EU) sources told the news agency, French and German officials had held discussions on just such a move.

“There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East," Barroso said.

Prime Minister Silvio Berlusconi touches his head as he makes a speech. Photo: Reuters

She called for changes in European Union (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 stays more loosely connected - a signal that some members may have to quit the euro.

“It is time for a breakthrough to a new Europe," 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."

The European Central Bank (ECB), the only effective bulwark against market attacks, intervened to buy Italian bonds in large amounts but remained reluctant to go further and Italy’s 10-year bond yields shot above 7%, a level widely deemed unsustainable, as investor confidence evaporated.

“Financial assistance is not in the cards," one euro zone official said, adding that the bloc was not even considering extending a precautionary credit line to Rome.

Policy vacuum

Italy replaced Greece at the centre of the crisis as Prime Minister Silvio Berlusconi’s insistence on elections instead of an interim government threatened prolonged instability.

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

He opposed any form of transitional or unity government, which the opposition and many in the markets favor, and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.

Italian President Giorgio Napolitano said there was no doubt over the resignation of Berlusconi once economic reforms were implemented by parliament within days.

“Therefore, within a short time either a new government will be formed... or parliament will be dissolved to immediately begin an electoral campaign," Napolitano said.

Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

Worries that the debt crisis could be infiltrating the core of the euro zone were reflected in the spread of 10-year French government bonds over their German equivalent blowing out to a euro era high around 140 basis points.


Policymakers outside the euro area kept up pressure for more decisive action to stop the crisis spreading.

Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe’s debt crisis risked plunging the global economy into a Japan-style “lost decade".

“If we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand."

Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.

Euro zone finance ministers agreed on Monday on a road map for leveraging the 17-nation currency bloc’s €440billion ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But there are doubts about the efficacy of those complex plans, and with Italy’s debt totalling around €1.9 trillion even a larger bailout fund could struggle to cope.

Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around €1 trillion would be ready by December.

Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank’s independence.

“The ECB will be drawn like everyone else by the weight of gravity (to act)," one euro zone official said.

“Core" zone discussed

EU sources told the news agency German and French officials had discussed plans for a radical overhaul of the EU that would involve establishing a more integrated and potentially smaller euro zone.

The discussions among policymakers in Paris, Berlin and Brussels raise the possibility of one or more countries leaving the zone, while the core pushes to deeper economic integration.

In a speech in Berlin, Barroso said Germany’s gross domestic product could contract by 3% if the 17-member zone shrank and its economy would shed a million jobs. “What is more, it would jeopardise the future prosperity of the next generation," he said.

Barroso said any push towards deeper integration should not come at the price of new divisions among EU member states.

Greek drama

In Greece, a deal on forming a national unity government collapsed as the country headed towards an economic abyss and revived early on Thursday the chances of former ECB vice president Lucas Papademos heading the coalition.

Papademos made his demands for both major parties to back the bailout package, which includes austerity measures that are likely to prove highly unpopular, amid warnings that Europe is running out of patience with Greece and may cut a financial lifeline that the party leaders seem to take for granted.

On a day that was bizarre and chaotic even by Greek political standards, Prime Minister George Papandreou wished his successor well and headed off to meet the president - only for it to emerge that there was no successor due to feuding in the political parties.

Papademos, whose candidacy had seemed doomed, insisted that both the socialist and conservative parties sign written undertakings to support Greece’s €130 billion bailout, as demanded by the EU, a government source said.

The outgoing prime minister had agreed to the terms laid down by Papademos, who as Bank of Greece governor oversaw the country’s adoption of the euro in 2002, the source said.

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