ROME -- Financial markets pounded Italy on Wednesday as investors hoped that Premier Silvio Berlusconi would not linger in office and delay reforms. Italy's president responded by declaring there was no doubt that Berlusconi would leave soon, appearing to soothe investors.
In another chaotic day driven by the European debt crisis, the Dow Jones industrial average dropped nearly 240 points in New York morning trading after Italy's borrowing costs soared to a new record high. Traders were troubled by signs that Europe's unending debt crisis was enveloping Italy -- the eurozone's third-largest economy, a nation too big for Europe to bail out.
And across the Ionian Sea, Greek lawmakers labored for a third day but finally came up with a deal to create an interim government to pass the country's new debt deal. Outgoing Greek Prime Minister George Papandreou, who was expected to formally resign with hours, wished the next prime minister well but gave no indication of who it would be.
Berlusconi has pledged to resign after the Italian parliament passes the financial reforms that European officials have been demanding for months. The process can take up to two weeks, but President Giorgio Napolitano said that would be accelerated to days, allowing him to quickly begin talks on forming a new government or calling new elections.
"Fears are totally unfounded that Italy may experience a long period of inactivity," Napolitano said, adding that "emergency measures" could be adopted at any time.
Italy's key borrowing rate spiked to a high of 7.40 percent on Wednesday, up 0.82 percentage points from the previous day, as markets expressed concern about how swift and complete Italy's political transition would be. That's over the level that eventually forced other eurozone countries like Greece and Portugal to seek bailouts.
They settled down to 7.26 percent after Napolitano's remarks.
"Berlusconi is the supreme political maneuverer. And no one will believe he has resigned until, yes, he has done so. Simple as that," said Jan Randolph, head of sovereign risk analysis at IHS Global Insight.
No one is suggesting that Italy is headed for an immediate bailout. Randolph said it will take a while for the higher borrowing rate to cause problems for Italy's "mountain of debt."
"With a catastrophic scenario -- and it seems we are facing now a catastrophic scenario -- maybe Berlusconi can be pushed to support a new government. Or maybe his party will crumble," said Roberto D'Alimonte, a political analyst at Rome's LUISS University.
Noted economist Nouriel Roubini, who has lived in Italy, expressed a similar view on Twitter:
"Yields at 7%: markets are telling Berlusconi to leave NOW. They don't buy his scheme of pretending to leave in 2 weeks after budget is passed."
D'Alimonte said investors are hoping for a technocratic government, led by former EU competition commissioner Mario Monti, who now runs the prestigious Bocconi University. Berlusconi and his allies claim such a solution would be undemocratic, however, because the conservatives won the last election.
With debts of around euro1.9 trillion ($2.6 trillion), Italy is considered too big for Europe to bail out. Higher borrowing rates will make it more difficult and expensive for Italy to roll over its debts. It has over euro300 billion ($412 billion) to raise in 2012 alone.
The European Central Bank has been buying up Italian bonds to keep yields at reasonable rates -- but Randolph said that is just throwing good money after bad.
"You can bring yields down, but they can't keep them down unless the borrowing government takes concrete steps to improve creditworthiness," Randolph said. "Seven percent is not sustainable over several years."
Italy needs to pass the additional austerity measures and structural reforms pledged by Berlusconi to world leaders at an economic summit last week.
Any delays in the financial reforms or in establishing a new, stable Italian government spook the markets, which are already unnerved since some investors in Greece are going to lose 50 percent of their holdings. Investors fear a so-called "haircut" could also affect those owning Italian bonds if Italy doesn't get its act together.
"Markets attack weak animals like lions," said political analyst Franco Pavoncello, president of Rome's John Cabot University. "Italy is perceived as being extremely weak politically, which is too bad because economically it is not too weak."
In the meantime, Berlusconi is not yet out -- and there is considerable uncertainty of what kind of government will follow.
While Berlusconi is not running for office again, he told the La Stampa daily he would remain active as the founder of his political party and would help out in any political campaigns.
Berlusconi wants new elections soon with his hand-picked successor, former justice minister Angelino Alfano, as a candidate. The 75-year-old leader tapped Alfano to head his People of Liberties Party a few months ago. At 41, Alfano represents a new generation of center-right politicians after 17 years of Berlusconi leadership.
But D'Alimonte said Berlusconi would still be pulling the strings.
"He will be the major protagonist of the next election. He will push Mr. Alfano as the candidate, but he will direct the orchestra. Alfano will be the first violin," D'Alimonte said.
The rising bond yields underline the quandary European officials find themselves in as they try to come up with an effective backstop for indebted countries, one with enough financial muscle to support the eurozone's No. 3 economy. European governments decided last month to increase the effective power of their euro440 billion ($600 billion) rescue fund, the European Financial Stability Facility, which is considered too small to bail out Italy.
European finance ministers are still working on the complex details of how to increase the fund's effective lending power to over euro1 trillion ($1.36 trillion) by having it partially insure government debt or by attracting outside investors. There are doubts among outside economists about whether either method will work.
The European Central Bank thus remains the only available outside firewall available against Italy's rising yields. It has been buying government bonds in the secondary market, which drives down borrowing costs for Italy.
But the bank has warned the program is only temporary. New ECB president Mario Draghi -- himself an Italian -- said last week it was "pointless" for European governments to expect outside help to drive down interest rates and the only solution was for them to reform their own finances.
Some analysts have speculated the ECB may be deliberately limiting its bond purchases to keep the pressure on Italy's reluctant government to push ahead with economic reforms.