According to the European Central Bank, the Italian banking industry now holds more government debt than the banks of any of the major European economies: nearly €324 billions worth of shaky bonds. The Spanish banking sector is also heavily overweight in government paper, at a new record high of €263 billion.
This bond-buying spree was caused by the "Sarkozy Trade," or the wild printing of euros by the ECB, which French President Nicolas Sarkozy hoped would relieve France's own public debt problem. As a result of his campaigning, any European bank can get all the euros it wants at the low, low price of 1% interest for three-year loans - and instantly convert it into its own government's bonds. Italian and Spanish 10-year bonds pay above 5.5%, yielding a 4.5 percentage point return for doing nothing (though whether this is a winning trade in the long-term depends on what happens after the first three years).
Just as in the US, private investors can no longer be counted on to purchase all the bonds that European governments would like to issue. So, the ECB is printing the euros to buy them - and thinly disguising the process by funneling it through the banking sector.
Sarkozy vs. Hollande
The "Sarkozy Trade" is actually considered a conservative policy in France, so investors certainly should not expect any improvement if Socialist candidate François Hollande wins the presidential election on Sunday. Hollande has promised to ease up on austerity and push the ECB even harder to devalue. This is just like here in the US, where Obama hasn't offered an alternative to Bush's policies so much as a doubling down on them.
Though Spain recently elected a center-right government, most of Europe is expected to follow France in this leftward shift - if for no other reason than most of the incumbents are moderately pro-austerity rightists and the electorates are running out of patience for reform. The lion's share of the resulting new government spending will surely be financed by bonds purchased by the ECB or banks using ECB money. This is a recipe for instability and inflation.
The Euro Plague
Greece caused the euro zone to catch the flu, but its economy is relatively tiny, smaller than 14 US states and 11 EU states. The national debt of Greece is around €347 billion, which is 159% of its GDP but still smaller in absolute value than its neighbors in Club Med. Italy, for instance, is over €1.88 trillion in the red (120% of GDP); the recently downgraded Spanish debt is over €706 billion (66% of GDP). These figures dwarf the €440 billion remaining in the European Financial Stability Facility after the Irish and Portuguese bailouts. So, if Greece gave the euro the flu, Spain and Italy are going to give it something like Ebola.
There are countries that have inoculated themselves against the euro plague by budgeting responsibly, forming overseas trade relationships, and, most importantly, staying out of the common currency. Switzerland's national debt is US$224 billion, 36% of its GDP. Norway comes in at US$97.4 billion, 49% of GDP. These aren't impressive figures compared to, say, Hong Kong (debt level: 10% of GDP), but at least they don't threaten failure of their monetary systems.