There has been no respite for Europe's policymakers from the debt crisis. For a little over a year they have tried unsuccessfully to contain the crisis within the smaller economies in the continent. A major reason for the failure lies with the policymakers themselves especially those from the bigger European countries that have a substantial stake and responsibility for the monetary union. Each time the crisis struck — first in Greece, then in Ireland and Portugal, and again in Greece — the policymakers, after much dithering, came out with solutions that were no more than fire-fighting exercises. Such short-sightedness has extracted a high price. Last week, Italy, the third largest economy in the euro zone, came under intense stress from the financial markets. Yields on Italian bonds jumped alarmingly. Milan stock exchange's index fell to its lowest levels in two years. Although the markets' initial reactions were exaggerated, it is clear that the debt crisis is entering a new, dangerous phase. By no means a pushover, Italy has a very high level of indebtedness. With an estimated $2.6 trillion outstanding, which is 120 per cent of its GDP, it has the largest amount of sovereign debt for any European country and the third largest in the world. If bond yields were to go up again, Italy's cost of borrowing will climb to unacceptably high levels.

Default by a major European country is simply unthinkable for now but even if, for whatever reason, Italy remains under stress, there will be huge, negative consequences, for the euro and the global economy. For a start, investors would flee European assets, making recovery that much harder. With the United States having major problems of its own, cross-border capital flows do not have the ready-made “safe haven” that they have been used to in times of great uncertainty. Consequently, flows will become extremely volatile. That will not be good news for countries such as India where capital flows pose major challenges to external sector management. The escalating debt crisis has once again called into question the sustainability of Europe's common currency mechanism without an accompanying fiscal integration. The euro, notwithstanding its present troubles, has eased trade and currency barriers and created a huge common market. Perhaps the most important lesson from the crisis is that any dependence on private capital for financing public expenditure — a course Italy and many other countries have chosen — can create stresses and strains on the national economy when they are least expected. Fortunately for India, policymakers learnt that lesson long ago.

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