If Italian Prime Minister Silvio Berlusconi left office, the market would lay off Italy, according to Nouriel Roubini, the founder of Roubini Global Economics.
“I think Italy has to do it, fiscal austerity, and even if they do it, the markets are going to be nervous about the credibility if this government,” Roubini told CNBC following heavy losses for European stocks on Monday. “I think that if Berlusconi was gone tomorrow, Italian spreads, even with the same policies, would be 50-100 basis points lower."
A crisis of confidence in the Italian government means the European Central Bank is needed to support the Italian bond market until the European Union approves its planned European Financial Stability Fund (EFSF), according to Roubini.
“Even when EFSF is approved, they are going to run out of money if they have to backstop Italy or Spain," he said. "Therefore you double or triple the EFSF resources.”
The other option is euro bonds, which Roubini believes could still not be enough to resolve Italy's problems if there is a liquidity crisis.
“There is also the idea of Eurobonds, (but) Italy or Spain could have a self-fulfilling run in which illiquidity can lead to insolvency even if the country’s not insolvent, just because the market panics and pushes the spreads to levels that are unsustainable,” said Roubini.
“So if you believe that Italy and Spain are solvent, they still need official money to avoid a bad equilibrium. It’s really like a bank run, run on the sovereign rather than the bank," he said.
Given his fears over Italy, Roubini told CNBC that Greece is the least of Europe’s problems.
“Greece is already undertaking a restructuring of its public debt. A 20 percent haircut was not sufficient, eventually it’s going to have to be 30, 40, 50 and Greece could even leave euro zone," he said.
While Greece could leave the euro in Roubini’s opinion, he is much more worried about the risk of contagion from “Greece to Portugal to Spain to Belgium to the French banks to German banks and so on."
“European banks are under stress because of exposure to sovereign debt and now a funding problem” said Roubini who believes Europe could end up having to triple the size of the EFSF’s funding or go with a Eurobond.
“In Italy and Spain we talk about 3 trillion euros of public debt, not a 100 billion. So orderly can be done in Greece with limited losses for the banks, but if you have to do it for Italy and Spain, then it will be a severe financial disaster for European financial institutions so we have to avoid that bad equilibrium from occurring," he said.