Remember the pain inflicted on the world by the Greek debt crisis? It wrecked the economy of most of Europe, caused our dollar to fall and made our stockmarket plunge.

Now Italy is the concern — Europe's nightmare scenario. If Greece was a sardine, Italy is a whale. Here are some comparisons: Greece's economy is less than one-third as big as Australia's. Italy's is 1.5 times larger.

That's why the potential for crisis in Italy is already making massive waves. Stock and bond markets have already fallen around the world.

A spike in Italian bond yields during May is due to fears Italy might not repay its debt. Photo / Supplied
A spike in Italian bond yields during May is due to fears Italy might not repay its debt. Photo / Supplied

The crisis might not come to pass, but if it does, all hell will break loose. That will be bad news for Australia — we have enough to deal with given rising unemployment, risks in China and the implications of a cooling housing market.

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What's wrong in Italy

The drama starts with politics, and bleeds into the economy. Italy had an election in March and it went down the Trump path, voting for candidates who are furious and want to shake things up.

The big winner was a party called the Five Star Movement. The Five Star Movement — founded by a charismatic Italian comedian, and with a leader aged just 31 — came out of nowhere. It stands for a fascinating mix of left-wing environmental and social policies plus an anti-immigration stance and suspicion of the EU.

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That's all fine for a democratic state. Italy is definitely not going well — unemployment is over 11 per cent. It needs reform. Italians have every right to vote for change.

But one problem at the March election was that several different parties all got a share of the vote. Nobody clearly won. (A bit like when Abbott and Gillard tied the 2010 election and there was a long period of uncertainty where we didn't have a government.)

Italy surfed along with no government for three months until this week, where the political crisis reached a point where their dramas spilled over into global economic markets.

The trouble arose because the anti-Establishment parties (not only the Five Star Movement but also a more right-wing one called the League) are growing in prominence and they don't exactly love the EU, or the euro.

People feared Italy could then have a referendum to leave the EU. This is like Brexit, but super-sized, because Italy uses the euro and the UK doesn't.

And if Italy stops using the euro, things could get ugly.

So they go back to the Lira. How bad can it be?

Italy's ties to European Union are under threat by political moves in the country. Photo / Getty Images
Italy's ties to European Union are under threat by political moves in the country. Photo / Getty Images

Bad. Leaving the euro will almost certainly cause a disaster.

The minute Italy gets its own currency (assume they go back to the lira) they have an exchange rate with the euro. You can bet the lira to euro exchange rate would suddenly crash. The lira will be worth a lot less. The debts Italy built up in euros suddenly look even bigger.

Imagine I owe you US$100 ($142.45) but I get paid in Aussie dollars. While you're waiting for me to pay, the Aussie dollar falls. You realise I now need to earn A$200 ($215.60) to change into USD to pay you back. You begin to doubt I will pay up.

That's the situation Italy would face if its currency crashes. People are already pretty sceptical about whether Italy can pay back its enormous debts and if they get bigger overnight, well, Italy might just default on them.

Read more: Markets will massacre Italy if it leaves euro

(Would it work to just set all the debt in lira? It would be easier for Italy to pay. But then the person at the other end takes the risk of the lira collapsing. Given that the person on the other end is probably a big bank, this idea may well cause bank insolvencies and a financial crisis.)

Legendary investor George Soros weighed in to say that the situation was worse than people imagined.

"It is no longer a figure of speech to say that Europe is in existential danger; it is the harsh reality," he said.

What is next?

Europe has a funny way of muddling through. Overnight a new Prime Minister was appointed in Italy in an attempt to stave off economic crisis. The man appointed, Giuseppe Conte, was not leader of either of the two populist parties who were causing such concern.

But clearly there's still a huge divide in Italy, with many Italians frustrated with immigration and being forced to stick with Europe-centric policies. A minority government of political novices is a highly combustible thing, and might not make it through an entire term.

As we all remember from the Gillard years, minority government is hard - there could soon be another eruption of trouble in Italy.

And that might be bad news for those of us who want a stable Europe.

- Jason Murphy is an economist. He runs the blog Thomas the Think Engine.