Italy and the euro need to stay together, but even if they do, they still might not survive.

Reuters
The globe's financial markets finally relaxed today after a week of mania over Italy's debt crisis. Despite some initial waffling, the country's government is poised to pass a series of reform measures meant to fix its shambling economy. That paves the way for Prime Minister Silvio Berlusconi to make good on his promise to bow out and let his likely successor, a widely respected former European commissioner, step in. Markets are up. European bond yields have eased.

Surely, as your read this, some frazzled banker is kicking back with a Campari and soda.

Yet, it's still too early to celebrate. Italy's reform legislation is the start of a solution, not the end of a crisis. Its economy, along with its marriage to the euro, will continue to be tested. And as desperately as the world needs that relationship to work, it may be doomed to fail.

WHAT'S HAPPENING IN ITALY NOW

The austerity measures making their way through Italy's parliament are an effort to save not only the country's economy but also the euro. Italy is the currency's third biggest economy, and its collapse, or possible defection back to the lira, its old currency, would have a devastating impact on the entire union. By taking steps such as privatizing services, selling state-owned real estate, and raising the retirement age, the government is hoping to win back the confidence of bond investors as well as its euro zone neighbors and salvage itself from disaster.

Those measures have already passed the parliament's upper house, and are expected to go for a final vote on Saturday. At that point, Prime Minister Silvio Berlusconi would step down. His heir apparent is Mario Monti, an economist and former European commissioner known as a consummate technocrat. In the clinical, data-oriented world of international finance and policy making, that's pretty much the highest compliment a public official can get, and his ascendance alone is abating some fears about Italy's future. In Europe's eyes, he's the man who can right the ship. But if he can't, the consequences will be ugly.

WHAT BREAKING UP WOULD LOOK LIKE

It's hard to exaggerate the gravity of Europe's situation. Italy is both too big to fail and too big to bail out. Italy's $2.6 trillion debt--that's more than four times what Lehman Brothers owed creditors when it filed for bankruptcy--reaches far and wide. But much of it lives with the banks of Germany and France -- the first and second largest economies in Europe. So a default would strike at the heart of the three largest markets in Europe. The result would be another global financial crisis.

Italy could address its problems by waving goodbye to the euro. Per the Economist:

Italy could write down its wages, prices and private debts at the same time as its public debts. All such contracts could be redenominated in a new lira, at a one-for-one exchange rate with the euro. The currrency would then "float" (ie, sink) to a discount to the departed euro on foreign-exchange markets. The size of that effective devaluation would measure the magnitude of Italy's default against its euro creditors. And the deeper cause of Italy's economic malaise, its chronic lack of cost competitiveness, would also then be addressed. A cheap new lira might even make Italian industry vibrant again.

But returning to the lira would still be a "catastrophic financial event," as Barry Eichengreen, a professor at the University of California at Berkeley blunty put it to me. It wouldn't technically be a default, but it would amount to the same thing, leading to a continental recession that drags down the world.

The problems would grow from there. Aside from the logistical nightmare of reintroducing a national currency on the fly, it would likely lead to a run on Italian banks as depositors rushed to grab as many valuable euros as possible before the big switch (that's assuming, of course, the euro itself didn't crater in value). Italy would also lose the trade advantages that come with membership in the EU, which could erase the benefit of a cheap lira. After all, most of its exports go to other European countries.

For it to be truly worth departing, Italy's economy would have to deteriorate to a point where it would have nothing to lose from relinquishing the euro, and everything to gain from wrestling back control of its currency. We haven't reached that point yet. But we might.

WHY ITALY COULD STILL FAIL

Italy's leaders are taking the first tentative steps toward fixing their country's mess. In return, they expect more support from the European Central Bank, and possibly the IMF. But there's a possibility all of this will be for naught.

The interim government will have to contend with the same cantankerous parliament that made life miserable for the old leadership. Election year is 2013. Given that its entire mission is to implement the unpopular belt-tightening measures sought by Europe's leaders, there's no telling whether it will be able to win the kind of popular support needed to sustain a reform effort.

And rest assured: the challenges ahead will be grueling. As the Independent reports, the current austerity legislation "contains none of the painful labor market reforms, such as making it easier to fire workers, that have been strongly opposed by unions." That's a big problem. As I wrote yesterday, Italy's broken labor market is one of the most important factors hamstringing its economy. Fixing that system might be politically poisonous, but it's crucial.

There's also the little question of whether the budget cutting measures sought by Europe's leaders are the right prescription for an economy that isn't growing.

Italy's crisis is complicated. The upshot is simpler. Either the idea of a single currency works, or it doesn't. Either Italy can be pressured to act more like Germany, and all will be well, or it may have been folly all along to think you could take away a country's control over its currency while leaving it control of its politics.

It's tough to ponder the fallout from that failure. But as Eichengreen put it to me, "The inconceivable becomes conceivable in strange economic times."