The repeated waves of fresh crisis and temporary hope in Europe are starting to look a lot like the Hokey Pokey. Last week, Italy briefly put its right foot in. Then, thanks to purchases of Italian debt by the European Central Bank, it put its right foot out. Meanwhile, everyone is calling on Germany to turn itself around, and Greece is still just shaking all about.
Until last week, much of the concern about European debt focused on relatively small countries with high debt/GDP ratios. In particular, Greece, Ireland and Portugal have debt/GDP ratios of 166%, 109%, and 106%, respectively. But Italy actually comes in at 121% debt/GDP, the highest of any European nation next to Greece. Far worse, Italy has a GDP that is 7 times the size of Greece, and is 3 times the size of Greece, Ireland and Portugal combined. So Italy's debt is not just huge relative to its own economy - it is just plain huge, at about $2.5 trillion in dollar terms. This is a terrible problem for France, whose banks are the largest single creditor to Italy, holding Italian debt worth about one-fifth of Italian GDP.
With Italian yields pushing past 6% and briefly passing 7% last week, Italy is actually very much in the situation that Greece was in about 18 months ago, when it was hoped that new "austerity" measures would shrink the deficit by forcing painful cuts in government spending. They didn't. The effect of austerity policies in weak economies is generally to damage the economy even more, causing a significant shortfall in tax revenues, so deficits don't materially improve despite the reduced spending.