Now Berlusconi faces his biggest test

After last week's Greek shenanigans, the future of the euro now depends on ability of Italy's premier to rein in his country's spending.

Tomorrow, the markets will start to place their bets on the likelihood of Silvio Berlusconi stopping the eurozone debt contagion spreading beyond Greece to lands that are too big to be rescued. Italy will begin, under International Monetary Fund supervision, to see if his government can rein in the spending that has already seen its debts reach 120 per cent of its entire GDP.

Thus will the stability of the eurozone be handed into the care of Europe's flakiest leader. It was not reassuring when, even after effectively being placed on probation by the IMF, Mr Berlusconi told Italian television: "Life in Italy is good. The restaurants are full. It's difficult to get a seat on a plane they're so busy; holidays are all booked up." At least in Athens yesterday there was a genuine sense of crisis, with solemnity to match.

Mr Berlusconi may feel differently on Tuesday, when the first of the votes on reforms to which he is now committed takes place, but just a few days ago he arrived at the G20 in characteristic fashion. His overcoat draped over his shoulders, he stepped from his limousine, and was soon caught by the cameras appraising the contours of Argentina's President, Cristina Fernandez de Kirchner, with a roué's smile. But, by the meeting's end, he'd been told with more force than ever before that he tends to spend far too much time studying the wrong kind of figures.

From tomorrow, his survival (and possibly that of the eurozone as we know it) will depend on only one vital statistic: the amount by which he can reduce Italy's debt. And to make sure he – or, if he falls, his successor – sticks to the task, an IMF monitoring mission will be invigilating Italy's efforts to reduce spending.

Yesterday, it was politics as usual in Rome: tens of thousands of demonstrators calling for his resignation, and Mr Berlusconi's routine refusal. He has promised a confidence vote on new legislation sought by the European Union to shore up Italy's economy. The measures include a plan to sell government assets, tax breaks to encourage employment for the young, and getting women back into the workforce. The legislation would also liberalise store opening hours and open closed professions.

The stakes for the country, the eurozone and the world economy could hardly be higher. Italy has debts of €1.9trn. It is the third-largest economy in the zone, and, unlike Ireland, Portugal or Greece, is far too large to bail out. If it defaulted, the basis of Western finance would be in shreds.

Mr Berlusconi, who recently rejected a proferred IMF line of credit, has been promising effective reforms for years, and insisting Italy was on track to rein in its public debt. He claimed his parliamentary majority was strong enough – despite mounting talk of defections on his own side – to pass legislation in the coming weeks containing an initial batch of reforms to sell off government property and privatise some local public services.

Among reforms are a rise in the pension age to 67 by 2026, a loosening of job protection, and new rules allowing civil servants to be put on so-called Cassa Integrazione, mandatory stand-down at minimum pay.

But the Italian Prime Minister, a born survivor incessantly besieged by litigation largely of his own making, has failed to deliver, and market confidence has withered in recent weeks. On Friday, Italy's benchmark 10-year bond yield jumped 0.32 of a percentage point to 6.43 per cent, indicating a surge in investor worries about the country, and, in particular, Mr Berlusconi's credibility.

The IMF chief, Christine Lagarde, said she hoped a quarterly monitoring mission would start by the end of November to check that the reforms Mr Berlusconi promised in a letter to the EU last month are implemented.

In Greece, the more pressing eurozone basket case, the political gamesof chicken continued yesterday. Prime Minister George Papandreou won an early-morning confidence vote in the socialist-led parliament on a pledge that he was willing to step aside and form a cross-party caretaker government. But yesterday afternoon the country's conservative opposition leader insisted on his demand for immediate elections, snubbing a government offer to form a power-sharing coalition. The centre-right New Democracy party leader, Antonis Samaras, described Mr Papandreou as "dangerous for the country", but did not say whether he would attend any negotiations with the government. Yesterday morning, Mr Papandreou met President Karolos Papoulias. He said at the meeting: "I am concerned that a lack of co-operation could trouble how our partners see our desire to remain in the central core of the EU and the euro." The country's creditors have threatened to withhold the next critical €8bn loan instalment until last week's new debt deal is formally approved in Greece.

The country is surviving on a €110bn rescue-loan programme from eurozone partners and the IMF. It is currently finalising a second mammoth deal: to receive an additional €130bn in loans and bank support, with banks agreeing to cancel 50 per cent of their Greek debt. His colleagues insist any new government would need until late February to secure the second deal, and have warned that a snap election could scuttle it. They insisted Mr Papandreou's offer to step aside was sincere, and called on Mr Samaras to reconsider his party's position urgently.

"If Mr Samaras were willing to back a new government, the Prime Minister would resign today," said Yiannis Magriotis, a deputy public works minister. Political analyst Ilias Nicolacopoulos argued it would be difficult for Mr Samaras to avoid the coalition talks altogether – even if he remains reluctant to share power with Mr Papandreou. "There will be a tough game of poker to determine what type of government can be formed," he said.

The extent to which events in Rome and Athens rendered the G20 summit a fringe production was illustrated on Thursday evening, when journalists dropped what they were doing in the basement of Cannes' Palais des Festivals to watch a live transmission from the Greek parliament in Athens, where Mr Papandreou was speaking.

The most likely way the eurozone could still get additional financing is through a special account under the auspices of the IMF, into which individual countries could make payments. Those investments in turn could then be used to boost the eurozone's own bailout fund, the €440bn European Financial Stability Facility. That way, countries such as the United States, which think Europe should pay for its own financial problems, wouldn't have to put any money in. And countries such as Russia and Brazil, which have expressed interest in investing in the eurozone, could.

But Germany's Chancellor Angela Merkel and Ms Lagarde said not a single country at the meeting made a firm commitment to participate.

Greece's long week

Tuesday Greece's Prime Minister, George Papandreou, announces referendum of the Greek people on the bailout package which says that, in return for austerity measures, banks owed money by Greece will accept losses of 50 per cent. The announcement causes surprise in Greece, and outrage in Brussels, where it is interpreted as a betrayal of assurances given. Market anxiety increases.

Wednesday Bailout funds of €8bn promised to Greece are postponed pending the holding of the referendum. There is growing market anxiety over Italy's stability after the cabinet fails to agree on a package of reforms.

Thursday Beijing opts to reject the eurozone appeal for investment in the European Financial Stability Fund. Mr Papandreou begins negotiations with the opposition on the formation of a coalition government, ahead of a parliamentary confidence vote on Friday night. Mr Papandreou causes confusion when he suggests that he may be open to cancelling the planned referendum.

Friday Greece drops idea of referendum. The G20 summit in Cannes is dominated by eurozone issues. Attendees commit to boosting the IMF's funding. The IMF and European Commission demand faster action on pension and labour market reform from Italy.

Yesterday Mr Papandreou narrowly survives a parliamentary confidence vote at a late-night parliamentary session. He promises to continue negotiations form a coalition government.

The future: The damage could dwarf even Lehman Brothers' collapse

Short term

George Papandreou, having survived a confidence vote on Friday night, must form a new coalition government. This could take about a week, but is already under threat from opposition party calls for snap elections. Such a move would inevitably delay government approval of the terms of the country's latest international bailout package, worth €130bn. Without those funds Greece will almost certainly default on its existing loans and go bankrupt next month. Italy's borrowing costs remain unsustainably high and the contagion effect of any further disasters in Greece could mean that Silvio Berlusconi will have to rethink turning down the offer of an IMF loan.

Medium term

If Greece is bankrupted, its membership of the euro must surely come to an end. The cost of borrowing for other countries would soar, which would almost certainly lead to yet another banking crisis – only, this time, one with the potential to dwarf the catastrophic effects of the Lehman Brothers collapse in 2008. Already it is unclear how Italy is going to refinance €300bn next year, though the IMF is sending monitors to Rome to issue quarterly updates on the country's economic progress. Spain will continue to slash public spending, particularly if, as expected, the PP opposition party wins this month's election. The party has promised to restore Spain's top credit rating, which will require the acceleration of spending cuts.

Long term

Eventually, France will have to stop providing so much money to the bailout funds. Its top credit rating would ultimately go, the consequence being that the European Financial Stability Facility's lending capacity would fall by at least one-third. If the rescue fund drops sharply, the worst-hit countries would lose much of the one source of funding that is keeping them afloat. Should confidence in the French economy fall, that would leave just the biggest, most important eurozone country left in the crosshairs of the crisis: Germany.