Italy's debt crisis: Why everyone is panicking

World financial markets erupted in turmoil this week, as fears mounted that Italy could default on its massive government debt. The crisis has already cost Italy's controversial prime minister, Silvio Berlusconi, his job. But why is it scaring people across Europe, and even here in the U.S.? Here, a brief guide:

Is Italy really in such bad shape?

In a word, yes. The country has financed years of lavish social benefits by borrowing and borrowing, piling up $2.6 trillion in sovereign debt. That's 130 percent of the country's gross domestic product of $2 trillion — way beyond what economists say any country can manage for long. As investors lose faith that Italy's leaders will ever get their finances in order, Italy is having to offer a higher and higher interest rate on its bonds just to borrow enough money to get by. On Wednesday, that rate spiked above 7 percent, the tipping point at which economists say a country's debt becomes unsustainable. Shortly after Greece, Portugal, and the Irish Republic hit that level, they had to be bailed out.

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Why don't European leaders just rescue Italy, too?

It's too big to bail out. It's basically "Greece on steroids," says Kevin Drum at Mother Jones. Italy's economy is the eighth largest in the world, more than six times larger than Greece's. And Italy owes its creditors more than Greece, Ireland, Portugal, and Spain combined owe. It would take nearly $1 trillion to rescue Italy, Capital Economics' John Higgins tells Forbes, but the European Financial Stability Facility — the EU's bailout fund — has as little as $340 billion left in it.

Can Italian leaders clean up their own act?

Maybe, but it might be too late. Berlusconi's final act was putting together an austerity plan that would slash the country's budget deficit from 3.6 percent of GDP to 2 percent, which is quite low. Take out the interest on its debt, and Italy already runs a surplus. But Italy has let its total debt grow so large that it will have to borrow 300 billion euros — "a massive 19 percent of GDP" — in private capital markets just to pay off bonds that mature in 2012. "No one wants to lend to a country when that country would use the loan to pay the interest on previous loans," says Robert Peston at BBC News, "That's throwing good money after bad."

What happens if Italy defaults?

Many people fear that Italy's collapse could send borrowing costs spiralling higher across Europe, spreading the crisis to other big economies, such as France. To pay off its debts, Italy might even abandon the euro and pay its creditors with a new domestic currency, at a one-to-one exchange. "The currency would then 'float' (i.e., sink)," says The Economist, and the magnitude of its drop in value would determine how much Italy's default would cost the banks and other investors that lent it euros. The losses could cripple Europe's financial system and spark runs on banks in Italy, then in other debt-burdened countries. Businesses would go under. The chaos could "send shockwaves around the world," says Michael Schuman at TIME, "that would rival, even possibly exceed, the ones we saw extend from Wall Street in 2008."

Sources: CNBC, BBC News, Mother Jones, MarketWatch, Forbes, The Economist, TIME