By Sara Eisen and Flavia Krause-Jackson

Feb. 17 (Bloomberg) — Italy, saddled with the euro region’s second-largest debt, is the “biggest threat” to the economy of the 16-member bloc, according to Nobel Prize-winning economist Robert Mundell.

“Italy has got to be worried,” Mundell, a professor at Columbia University, said today in a television interview in New York. “If Italy became a target then this would create a big problem for the euro. Whatever is being done to Greece, possibly to Portugal and maybe Ireland, has to also save Italy from that problem.”

Italian officials have tried to prevent Italy from being lumped together with some of the euro zone’s smaller economies – - Portugal, Ireland, Greece and Spain — that have drawn investor concern about their ability to control deficits and debt. Italian Prime Minister Silvio Berlusconi said Feb. 10 that those nations were doing “much worse” than Italy and that the “markets have given us their faith.”

“It would be very difficult if Italy got tarnished with the same problem,” Mundell said, referring to the risk the European Union may need to provide financial assistance to some of its members. “It would be very difficult to bail out Italy.”

Mundell won the Nobel Prize in 1999 for research that helped lay the foundation for Europe’s single currency.

Slow Growth, High Debt

The Italian economy, Europe’s fourth-biggest, risks falling back into recession after contracting 0.2 percent in the fourth quarter. Debt will rise this year to 117 percent of gross domestic product, the second highest in the EU after Greece, according to the European Commission.

Italy’s high debt level would create problems for the entire euro region if rising financing costs make it difficult to service the country’s borrowing, Mundell said. Italy has about 1.8 trillion euros ($2.5 trillion) in debt, more than five times that of Greece and the equivalent of about a quarter of the euro zone’s debt.

If markets were to lose confidence in Italian public finances, then the European Central Bank would have its hands tied by the Maastricht Treaty, which says the central bank must orient monetary policy exclusively toward keeping inflation under 2 percent.

Monetary Policy

“The Treaty of Maastricht puts a straight jacket on the ECB,” Mundell said. “Monetary policy itself would have to bend a little if a country as big as Italy got into trouble.”

Other economists disagree with Mundell on Italy’s potential threat to the euro zone.

“The situation in Italy is much better than it is in Greece or Portugal, for one thing: the fiscal deficit,” Marco Annunziata, chief economist of UniCredit SpA, said in a radio interview in New York. Italy’s level of competiveness is also better than Greece’s, he said.

Debt aside, Italy’s 2009 budget gap of 5.3 percent of gross domestic product was about half the size of the shortfalls in Portugal, Ireland, Greece and Spain. Those countries have all been downgraded in the past 18 months and have negative outlooks. Italy, by contrast, has retained its stable outlook and its last credit-rating cut was in October 2006.

Italy’s competitiveness rose one notch to 48th place in the World Economic Forum’s 2010 ranking. That’s lower than Spain, Portugal and Ireland, though higher than Greece, placed 71st.

The premium investors demand to hold Italian 10-year debt over comparable German government bonds was little changed today at 85.6 basis points. That’s up from 75 at the beginning of this year. The gap between Greek and German bonds was 314 basis points, about 75 points higher than at the start of 2010.

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