Eurozone growth forecasts were slashed on Thursday as the sovereign debt crisis entered a dangerous new phase.
Markets are on tenterhooks as Italy's cost of borrowing remains close to unsustainable levels and rumours spread that core countries are losing patience with the single currency area's weaker members.
The European Commission has dropped its estimates for gross domestic product (GDP) growth in 2012 from 1.8% to just 0.5% and warned that the risks of a recession have increased.
Calling the report "The last wake-up call", European economic and monetary affairs commissioner Oli Rehn warned that the recovery in the EU has hit a standstill.
While the headlines have long been captured by short term drama in the periphery, manufacturing and consumer figures have been pointing towards a slowdown for some months, with longer-term analysts worried that Europe's real problem is growth, not debt.
The yield on Italian 10-year bonds dipped below 7% on Thursday morning as the European Central Bank (ECB) intervened to try to put a ceiling on the country's cost of borrowing.
The number is seen as a sign that the country's debt is now unsustainable, and that with private investors losing confidence the only option left could be a bailout by international financial institutions.
"Yesterday was probably the worst day in observable history for Italian debt," Deutsche Bank strategist Jim Reid warned on Thursday. "We are way through levels which were previously viewed as unsustainable."
That European bailout mechanisms are not yet in place to deal with a spiralling crisis in the eurozone's third largest economy fuelled fears amongst investors that there might be nothing standing in the way of a catastrophic default that would send shockwaves across the international financial system, except for an Italian government beset by infighting and politicking.
The ECB seems to be being drawn inexorably towards operating as a de facto lender of last resort for Europe, despite insistences by the institution that it does not want to take on that role.
The main eurozone crisis fund, the European Financial Stability Facility (EFSF) was promised additional firepower in October, in order to reassure markets that it could both recapitalise banks and bailout countries.
However, the funding for the EFSF is not in place, and its structure - issuing bonds backed by the core countries - is vulnerable to the poor performance of those economies.
France has been seen as vulnerable to a downgrade for months, and its austerity measures are appearing increasingly vicious. If France loses its top rating, the EFSF may do the same, raising the costs of bailouts and creating another negative feedback loop for Europe. Spreads between the German bonds and EFSF bonds issued in the summer already show weakening investment confidence in the mechanism.
With the crisis once again moving ahead of policymakers' ability to deliver responses, markets are asking whether the EFSF may be too little, too late for Italy and the single currency.
Ending the turmoil in the market requires an almost unlimited commitment, Ed Smith, a strategist at Collins Stewart Wealth Management said.
"I don't see this ending now until an open-ended backstop is put in place," Smith said, noting that if the ECB merely indicated that it was willing to print enough money to solve the crisis, it could have the effect of reducing the pressure on individual sovereigns.
"Sometimes the commitment to buying obviates the need to actually do so," he added.
UK Prime Minister David Cameron called for immediate action from eurozone leaders and an opening up of the ECB's coffers on Thursday. Investors agree.
"Days like yesterday bring forward the point where Europe will have to decide what it ultimately wants," Reid wrote. "If it's the status quo in terms of members and debt then they might have to find a way to change the remit of the ECB. If the ECB is sacrosanct then everybody might have to eventually shake hands and go their separate ways or at least accept that haircuts are here to stay."
The real threat of a country exiting the euro was raised in the aftermath of now former Greek Prime Minister George Papandreou's doomed decision to put part of a key eurozone rescue package to a referendum, and that the core countries are building contingencies in that eventuality is hardly surprising.
The German government has denied Reuters reports that it is preparing for a reorganisation of the single currency area and the wider EU, but the fact that the subject is no longer taboo is significant, BNY Mellon currency strategist Simon Derrick said in a note to clients on Thursday.
"No longer is it unimaginable that a disorderly default can happen in a country within the Eurozone or that a nation can end up leaving the single currency. Indeed, given the news flow yesterday, it seems entirely possible that the euro could end up changing its membership very rapidly indeed. The Eurozone is therefore faced with a stark choice: either it changes what it is - a “stability union” if we needed reminding - or who its members are," Derrick wrote.
European markets actually edged up on Thursday afternoon and then, with the exception of Germany, dipped back down before the close.
The Dax gained 0.63%, while the CAC-40 was down 0.38%. The FTSE 100 was flat mid-afternoon but dived half a percent in late trade. Investors had fled from stocks on Wednesday as they pulled back on risk. Analysts have warned, however, that if nothing concrete emerges overnight, tomorrow could see further falls as investors position themselves defensively ahead of what could be a long weekend of political negotiations.
Should a resolution not be found in the near term, there is the real risk of severe damage to the banking sector and the wider economy, analysts warned.
European leaders have already committed to recapitalising banks to prevent losses from peripheral debt from overwhelming their ability to lend to the real economy, but with Italy now also under threat, the scale of that recapitalisation is also being called into question.
German and French banks are particularly exposed to the sovereign debt of the 'Gipsi' countries - Greece, Italy, Portugal, Spain and Ireland - and any rolling default or haircut would probably cost them far more than they would be able to absorb, even with additional capitalisation.
That could lead to bank liquidity, and hence credit, drying up and worsening already slow growth. It would also have an international dimension, spreading well beyond the borders of the single currency area.
"Something needs to happen fast," Smith said. "What began as a sovereign solvency issue has become problem of bank liquidity, and we're beginning to see a credit crunch in its purest form."