The imminent end of Prime Minister Mario Monti's governmentfueled the largest increase in Italian borrowing costs in fourmonths and threatened to open a new front in Europe's crisis fightbefore a year-end summit.

Italian 10-year bond yields jumped 36 basis points to 4.89percent at 12:18 p.m. in Rome, widening the difference betweenyields on German bunds of similar maturity by 38 basis points to361 basis points. Italy's benchmark FTSE MIB stock index fell 3.4percent, while Germany's DAX Index slipped 0.6 percent.

Italy's government crisis, which pits Monti against billionaireformer premier Silvio Berlusconi, is roiling investors and bringingtensions among European Union leaders to the fore. EU heads ofstate and government, gathering in Oslo today to collect the NobelPeace Prize, are seeking to present a united front as the resurgentBerlusconi hits the campaign trail with his German-skeptic,anti-austerity message.

“The underlying cracks within the euro zone are actuallywidening,” Georg Grodzki, head of credit research at Legal &General Investment Management in London, which has about $290billion of bond funds, said in an interview yesterday. “Investorswill be reading Italian politicians' lips very, very closely.”

The Italian election campaign puts the EU's budget policy up forreview in the 27-country area's fourth-largest economy. Monti, 69,said Dec. 8 he will resign due to parliamentary opposition fromBerlusconi and his allies, who had previously backed thegovernment. The unelected premier is undecided about whether toseek a second term, Italian daily La Repubblica reported today.

Monti will hand in his final resignation after making an attemptto muster parliamentary support for the 2013 budget law. A vote isdue before the end of the year. Elections will be held 45 to 70days after President Giorgio Napolitano dissolves parliament. Inthat interim period, Monti may remain premier, or Napolitano mayappoint a caretaker.

Under Monti's 13-month-old government, Italy's 10-year bondyield has declined more than 200 basis points and the governmentlast month sold debt at the lowest rate in two years. His austeritymeasures, while deepening the country's fourth recession since2001, have also left the nation on track to bring its deficitwithin the EU's limit of 3 percent of gross domestic product thisyear.

Improved Image

“Italy's image has improved markedly thanks to the Montigovernment, and all that could be reversed,” Riccardo Barbieri,chief European economist at Mizuho International Plc in London,said in a research report today. Berlusconi “has repeatedly arguedthat the pros and cons of leaving the euro must be better analysedand considered.”

At a summit in Brussels on Dec. 13-14, EU heads of governmentwill debate a road map for the overhaul of the euro area, includingincreased powers to intervene in national budgets and theestablishment of a single banking supervisor. Finance ministerswill meet first, on Dec. 12.

Finding consensus in the EU may become more difficult withoutMonti, who overcame German resistance at a summit in June to brokera common pledge to aid members in financial distress. Berlusconi,who was pushed from power last year after proving unable to protectItaly from the debt crisis, announced Dec. 8 he will seek thepremiership in next year's election and criticized Monti forrunning a “German-centric” program.

“The 2013 Italian election remains high on our list of tailrisks,” Holger Schmieding, chief economist at Berenberg Bank AG inLondon, wrote in a note yesterday. “A Berlusconi campaign against'German austerity' could potentially unsettle markets.”

Italy's economy shrank 0.2 percent in the three months endedSept. 30, the fifth consecutive quarterly decline. The economycontracted 2.4 percent on an annual basis and household spendingfell 4.8 percent from a year earlier.

Italy faces about two months of campaigning as Berlusconi, 76,seeks to reverse an opinion-poll slide by disavowing his ties toMonti and appealing to an electorate weary of tax increases andrecession. Berlusconi's People of Liberty party had 13.8 percentsupport in an SWG Institute poll released last week, compared with30.3 percent for Monti's biggest remaining backer, the DemocraticParty.

Legal Woes

Berlusconi, who was sentenced in October to four years in prisonfor tax fraud, is free pending appeal. In an unrelated case, he isstanding trial on charges of abuse of power and engaging a minor inprostitution, allegations he has denied.

“The ability of Silvio Berlusconi to spook investors knows nobounds,” Nicholas Spiro, managing director of Spiro SovereignStrategy in London said in an e-mailed message. “Mr. Berlusconi isnot the cause of Italy's deep-seated and long-standing economicproblems, but he epitomizes the dysfunctional nature of Italianpolitics, with its discredited leaders and unstablegovernments.”

Pier Luigi Bersani, head of the Democratic Party, won a primaryelection this month to head a coalition of center-left parties ingeneral elections. Bersani's biggest challenge may come from theanti-austerity Five Star Movement of comedian-turned-politicianBeppe Grillo, which had 19.5 percent support, making it thesecond-most popular party.

Bersani said in an interview published today by the Wall StreetJournal that he would seek greater flexibility in EU budget rules,while confirming he would respect the covenants. Bersani has toldvoters he plans to ease portions of Monti's budget-saving pensionreform.

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