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The word “economy” comes from the Greek “oikos” or “house.” Lately, the global economy has been like a nightmare episode of “Holmes Inspection.” You know the one. The owner fixes one problem only to find a more insidious problem underneath. Confidence in the contractor quickly turns into fear of the unknown and soon a new floor turns into a new foundation. It all goes way over budget and none of it is to code. It’s how big renovation projects go bad all the time and it’s how troubled economies become economic disasters. Unfortunately, America doesn’t have Mike Holmes to come to the rescue and make everything right.

While the trouble with the global economy may seem safely quarantined by the Atlantic Ocean and the boundaries of the European Union, Americans should be on high alert, because things could go from bad to unimaginably bad with one bad economic resolution “over there.”

The big news of the past week was that Greece would get bailed out and be leaving the money pit of “This Old Economy.” On this week’s episode: Italy.

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Ah yes, just when the eternal optimists among us were beginning to feel slightly better about chances for a modest recovery, another international domino begins to totter and potentially threaten the fabric of the world economic situation, again. The Italian economy seems to be unsustainable and default on its sovereign obligations seems imminent. The situation in Italy is really much worse than the one that seems to have been resolved very expensively in recent weeks in Greece.

Italian debt has ballooned over many years and now stands at a staggering 130% of its GDP. In order to meet its obligations, Italy will have to borrow some €300 billion in 2012, about another 20% of the GDP. Unfortunately, even that unthinkable amount will barely sustain the status quo. The bailout of Greece was accomplished by several public and private institutions, most prominently big European banks agreeing to take as much as a 50% haircut on their debt. In contrast, Italy is a much larger economy and likely cannot go down the same path. The stronger economies of northern Europe simply cannot afford to bail out the largest economy in southern Europe, especially with Spain and Portugal lurking behind Italy with similar problems.

So now you’re thinking, OK, Levin, thanks for the global village primer, but what does all of this really have to do with me?

Here’s the deal. First and foremost, has your stomach been churning lately as the stock market has been doing its impression of a seismographic needle during a 6.0 earthquake? I think by now, it has become pretty obvious to a whole lot of people that our stock market is extremely susceptible to negative swings resulting from problems in Europe. Make no mistake, mutual funds and 401(k)s can be very directly affected by any European collapse.

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Judging by how the market reacted to the mere threat of default from the relatively small economy of Greece, the much larger problems in Italy could easily herald a more significant decline in U.S. stock prices, at a time when many of us need to rely on retirement funds that either are directly or indirectly invested in U.S. equities. Worse, an Italian default is much more likely to produce truly systemic problems for the EU, quite possibly signaling the end of the euro, or at least the rebirth of the lira.

Secondly, the EU taken as a whole is the world’s largest economy, and a very important consumer of U.S. exports. Given the anemic consumer demand in the United States, a drop in exports to Europe at this moment would likely derail the meager growth we in the U.S. have experienced over the past few quarters.

But most importantly, an Italian economic debacle could easily trigger a European economic debacle, resulting in the failure of the European banking system and rampant political instability (as if there weren’t enough already).

Remember what happened in the United States just three years ago? After the collapse of Lehman, the notion that our entire financial system could self-destruct became, at least for a time, believable. Credit froze solid for a period of several months (not that anyone I know is feeling the warmth of a thaw at the moment) and many people didn’t need to reread HG Wells to time travel to the ’30s. We really were teetering on a very sharp edge.

Now, whatever your thoughts about the bank bailout in the U.S., or the behavior of the mega-banks following the bailout, without it a Hoover-style depression was quite possible. And ultimately, what the Fed did in bailing out the banks was essential to rebuild confidence in the U.S. financial system—not just the confidence of the American people—but the confidence of banks, institutions and governments around the world.

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Europe: The Confidence Game That Could Break the Bank (cont.) »

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