Now that the troika – the European Union, European Central Bank and the International Monetary Fund – has manhandled the Greek political system, they will probably turn their attentions to Italy. Despite the deal reached a couple weeks ago to “save the euro,” Italian bond spreads (the difference between German and Italian bond rates) keep rising. While nowhere near Greece’s spreads, borrowing costs for Italy are now at a record high since adoption of the euro. And far from a peripheral country like Greece, Italy is the third-largest in the EU, a member of the Group of 8.

The whole point of forcing a solution on Greece was to stop “contagion,” the spread of the borrowing difficulties, to the bigger countries in Europe like Italy and Spain. Italy’s experience shows this is not working.  From the New York Times:

The yield on 10-year Italian notes has surpassed that on Spanish debt by nearly a full percentage point, reaching 6.51 percent on Monday after leaders at a meeting last week of the Group of 20 nations failed to come up with details on how to stop the European crisis from spreading. The rising yield is troubling because once the interest rates on the debt of Greece and Portugal surpassed 7 percent they shot up far higher, requiring those countries to turn to outside sources of financing. Rates on their debt remain in double digits.

At the end of last month, Italy issued 3 billion euros worth of bonds at an interest rate of more than 6 percent, about 1.5 percentage points higher than it had had to pay as recently as the summer. The extra bond yields are adding as much as 3 billion euros (about $4.1 billion ) annually in additional interest payments, estimates Tobias Blattner, a former economist at the European Central Bank who is an economist at Daiwa Securities in London.

Analysts are concerned that if interest rates on Italian debt keep rising, the country may no longer be able to afford to borrow on the open markets and instead would have to turn to official lenders like the European Union or the International Monetary Fund.

The latest rate “is a warning,” said Mark McCormick, currency strategist at Brown Brothers Harriman. “Seven percent would be a point of no return.”

The European Central Bank had been buying up Italian and Spanish debt, and this held down the numbers for a while, but that has ended. So when all you have is a hammer of austerity, every sovereign citizenry looks like a nail. So the solution for the troika, predictably, is that Italy needs to reduce their borrowing costs and show “seriousness” to the markets through another round of cuts.

And this has led to a political crisis in Italy, featuring one of my favorite world leaders, Silvio Berlusconi.

Prime Minister Silvio Berlusconi struggled to hold on to power and prove he can implement austerity measures pledged to European Union allies as reports of his imminent resignation sent Italian stocks surging.

News agency Ansa said Berlusconi denied a report by Giuliano Ferrara, his former spokesman and editor of newspaper Il Foglio, who wrote today that the premier would step down “within hours.” Berlusconi will likely resign next week in return for support in a vote on the austerity and economic- growth measures, Ferrara said in a phone interview after his initial report.

“It’s very urgent” for Italy to pass the measures, Ferrara said. “Berlusconi should ask for a confidence vote to do that and then he should step down and ask for elections.”

We know there will be a confidence vote tied to austerity, but Berlusconi may not have a majority in Parliament by then. Three members of his party have defected to the opposition in the last week. Berlusconi only won his last confidence vote by the thinnest margin possible, with 316 of the 630 members of the Chamber of Deputies. The fact that Berlusconi is constantly in and out of criminal and civil trials over his womanizing can’t be helping matters.

In elections, Berlusconi’s party is scheduled to fail according to polling, as he is now an unpopular figure in Italy. So I’d expect the troika to get to the opposition, a coalition of leftist parties, pretty quickly, and force them to knuckle under to austerity. It’s the European way. Even France is getting in on the act. This is causing a death spiral across Europe of austerity contracting economic growth, leading to more austerity. Lather, rinse, repeat.