Another month, another one of the PIIGS makes headlines for its impending financial meltdown.  (PIIGS stands for: Portugal, Italy, Ireland, Greece, Spain.)  This time it’s Italy, bumping Greece out of the news for the meantime.  The problem is, Italy’s situation is far more dire when viewed through the lens of the global economy.  The fact that Italy is Europe’s third largest economy alone would account for that fact, without even factoring in the growing strain all of these recent bailouts have placed on the EU.

Let’s back up for a second and see how we got here.

In general, the entire PIIGS crisis can be summed up with the following statement: the countries in question borrowed more money than they were making.  In slightly more technical terms, they borrowed too much relative to their Gross Domestic Product (GDP), to the extent that they are now unable (or having serious difficulty) meeting their fiscal obligations.

How did Italy get into this mess, specifically?  This article, titled “Italy’s Debt Crisis: Doomed by Corruption, Bloated Bureaucracy and Poor Productivity,” is a good primer on the basic reasons, and I’ll attempt to sum them up here:

1) First and foremost, perhaps as the general and foundational reason behind Italy’s woes, is the fact that it’s overspent by 1.9 trillion euro, or 120% of GDP.  

2) Corruption is widespread, with Italy’s Mafia accounting for nearly 16% of GDP.  (Obviously, this economic output isn’t necessarily optimized to aid the country’s growth.)  Tax evasion isn’t just limited to the criminals, as ordinary citizens have seemingly embraced it as a national pastime.

3) Bloated bureaucracy is an enormous cost unto itself.  Italy’s politicians earn 140,000 euro a year on average, and are driven around in executive cars (Audis, Maseratis, etc.) that cost the country 2 billion euro a year.

4) Italy’s education system is extremely poor, with only one of the world’s top 200 universities located in Italy (University of Bologna).  To underscore this, Italy’s unemployment rate for youth between the ages of 15 and 24 is a staggering 30%.

As you can see, many of Italy’s problems are systemic, and have gradually led the country into a worsening position financially.  The irresponsible government spending is really only the tip of the iceberg.

So where do things stand as of today?  Italy’s borrowing costs have rapidly increased over the last several weeks, hovering around 7% as of the writing of this article.  These government bond yields are a good yardstick for determining how unstable things have become, and it’s interesting to note that the other three EU nations that required bailouts (Greece, Portugal, Ireland) had also reached the pivotal 7% mark when they received emergency assistance.  These higher yields reflect investors' declining confidence that Italy can and will repay the debt.  Thus, they are seeking a higher premium for taking the risk of buying these bonds.

The outlook for Italian citizens is grim.  This past weekend, austerity measures were proposed that would result in a familiar combination of remedies -- spending cuts and tax increases – with the goal of balancing the budget by 2014.  Expect Italians to vehemently protest these measures.

External to Italy, I expect things to worsen significantly as we head into 2012.  The previous bailouts of EU nations have cost billions, and ultimately have done little to stem this contagion.  How much more money will the EU have to conjure up (read: print) in order to save Italy?  Not to mention the possibility of Spain and other countries requiring similar assistance in the near term.  

I cannot understate the severity of the aftershocks the collapse of Italy would cause for both the global economy and the US in particular.

Let’s walk through a possible vignette on how things could get ugly quickly if Italy goes down (keep in mind, this is a highly simplified example, and only one of many possibilities that could arise):  Italian bonds are bought and held by a wide variety of institutions around the world.  Let’s assume a host of Italian banks hold these bonds, and are informed by the Italian government that many of them will either only be paid back to a partial extent, or perhaps not paid back at all.  Several of these Italian banks would then presumably go insolvent, especially if they have high exposure to the bonds.  The same goes for other EU banks holding those bonds, as well as EU banks that had other types of holdings with the Italian banks that are suddenly failing.  Several of these EU banks would then go under, as well.  Here in the US, banks holding Italian debt, and/or invested in any way in the Italian and/or EU banks that are going insolvent, would also be subjected to potential insolvency.  As the EU collectively attempted to inject monetary assistance into the system, the very stress that cost would create would likely exacerbate the matter and trigger even more bank failures, insolvencies, and related bankruptcies. 

In other words, an enormous chain reaction would be set off.  If you think of the global economy as a massive series of interconnected/interdependent nodes, then you can begin to envision how the failure of several of those nodes begins to propagate negative consequences across the entire network.

This scenario would not be pretty for your investment portfolio.  Recent market perturbations and EU/PIIGS anxiety have already spooked the average investor, and this is just a taste of what’s to come.  Now is the time to review your portfolio and determine how much exposure you have to the kinds of systemic risks I’ve discussed here.  Gauge how high your risk tolerance is and then make defensive adjustments as necessary.  If you have extra cash, you might also consider betting that a collapse will occur, and invest in options or other high leverage instruments.