In recent years, the concern was for the debt crisis involving the three little pigs (Portugal, Ireland and Greece); little in terms of the relative size of the economies. A big fear was whether it would be spread to the larger economies of Spain and Italy. Now it's spread to Italy and action needs to take place quickly to limit the damage.
The European Debt Crisis spread to Italy a little fast than some anticipated. Much has written about it elsewhere (for example, here's a Bloomberg story about the crisis and the impact on growth in Europe), but let's summarize the key issues. Italy is the third largest economy in the eurozone (behind Germany and France), much larger than Greece and there aren't enough funds currently available to "bail" it out. Though the Italian budget deficit is "only" about 4% (high by pre-crisis standards, not that high by current standards), it's national debt is about 120% of GDP (very high, second to Greece in the eurozone). In addition, growth is expected to be very weak for years to come, limiting its ability to finance its debt. Combine that with a lack of confidence in the Italian government to adequately address the problem (contain debt while promoting economic growth) and you have the next round of the debt crisis. In recent days, interest rates on Italian debt soared passed the critical 7% threhold. Each of the other pigs needed bailouts after yields on their bonds rose past 7%. So what matters is the amount of debt, the cost of financing the debt, and the ability to finance the debt.
Reuters has a nice debt spiral calculator for Italian debt. You can use it to estimate the policy response necessary to stabilize Italy's debt-GDP ratio given certain assumptions which you can adjust. For example, if nominal GDP grows by 2.5%, current policy would stabilize debt at its current high level (120%) at an interest rate of 5.6%. At an interest rate of 7%, it would need to make significantly more budget cuts just to keep the debt from rising (reduce spending on other items in order to pay the higher interest on the debt).
As of this morning, things have stabilized a little as the European Central Bank intervened in financial markets by purchasing existing Italian bonds (it's prohibited from buying new bonds), helping to push rates on some bonds to below 7% (one-year, five-year). This doesn't solve the problem, but may help to buy a little more time to try to develop a solution. Meanwhile, Italy was able to auction new one-year bonds at a rate of 6% (compared to market rates of 8% yesterday, but 3.5% at the previous action). Also, the Italian government is putting approval of its budget on the fast track (try to approve it this weekend) and plans to follow its passage with the formation of a new government. Unfortunately, this story is still unfolding.
