Italy: Definitely too big to fail, maybe too big to bail

Italy is struggling to deal with a massive debt load as bond yields top 7% and Prime Minister Silvio Berlusconi gets ready to resign.

NEW YORK (CNNMoney) -- Douglas J. Elliott, who worked as an investment banker for two decades, is a fellow at the Brookings Institution.

We may be nearing the finale of the Euro crisis that has been building for at least a year and a half.

What Italy does now, and how governments and markets respond, may determine whether we have been watching a tragedy or something less serious.

Whatever it is, it definitely has elements of both.

Italy is the domino that cannot be allowed to fall over, because it would risk knocking over too much else.

Yet it is also so large that saving it requires huge financial resources. Italy has well over $1 trillion of government debt, about 1.2 times the annual output of the whole nation.

It cannot afford to pay an interest rate of 7% or 8% without major cutbacks, so the rates now demanded by the market are unsustainable.

Official: Italy will adopt austerity measures

Either Italy and its partners in the eurozone calm the markets, or Italy is likely to eventually restructure its debt by imposing losses on the current bondowners. A big problem is that cutting the debt could impose half a trillion dollars or more of losses on other parties.

Such a level of losses would do real damage to the European financial system and both directly and indirectly on the wider economy.

Worse, an Italian default would almost surely force defaults by Spain, Portugal, and perhaps Ireland, since their access to the bond markets will dry up as justifiable fear spreads. (Why own a bond paying even 10% if you think 50% losses may soon be imposed?)

This matters because Spain is nearly as big as Italy.

Eurozone governments and the European Central Bank would be well-advised to prevent an Italian default at almost any cost (as the rest of the world has been screaming recently).

However, there are three reasons we might be watching a tragedy and not a drama with a happier ending. First, backing Italy means someone has to take a huge amount of financial risk.

The probability of loss would be low, done right, but the maximum potential loss would still be high. No one is eager to step forward. Second, Germany, Europe's deep pocket, is understandably insistent that any support comes with very tight stings attached to ensure the money is not frittered away.

Italy's political system is deeply flawed right now, making it very difficult to provide assurances -- hard for even a sounder country to provide.

Third, the governance of the eurozone requires an amazingly complex dance among 17 countries, each with their own politics, financial systems, and economic circumstances.

Europe's worst case scenarios

There are many, many ways that the complexities could prevent the necessary steps. I think that an Italian crisis is likely to eventually force strong, concerted, and comprehensive actions that will save the eurozone.

But, there is maybe a one in four chance of disaster. As I have advised before, keep your fingers crossed. A collapse of the eurozone would plunge the U.S. into recession again.