By Paul Taylor

ATHENS (Reuters) - The euro zone's debt crisis has taken a dangerous turn. Contagion is singeing the currency bloc's third biggest economy Italy, which would be too big to save with existing EU financial fire-fighting tools.

The cheapest way for Europe to build a firewall to shield Italy would be to take decisive action this month on a second bailout for Greece, market participants and EU officials say.

The longer a decision is delayed, the greater the risk of events getting out of hand in Greece or on capital markets, forcing core nations to take more radical and politically difficult measures to hold the 17-nation currency zone together.

The choice would then be between closer fiscal union and a possible breakup of the euro area.

Options long ruled out by EU paymaster Germany, such as jointly issuing euro zone bonds and possibly swapping the debt of Greece, Portugal and Ireland for such instruments at a discount, would be back on the table with new urgency.

"We continue to believe that core Europe will end up bailing out peripheral Europe as the cost of not doing so is at least double the cost of doing so," Credit Suisse analysts said in a research note on Tuesday.

Euro area finance ministers, still split over how to involve private bondholders in a second rescue package for Greece, failed to take any immediate decision on Monday night.

Ominously, they accepted for the first time the possibility of some form of Greek default, despite dire warnings from the European Central Bank, sending global stocks and bonds tumbling.

Meanwhile, the International Monetary Fund is stepping on the brakes, with new managing director Christine Lagarde saying the global lender is not yet ready to start discussing a second rescue package for Athens.

Domestic politics in Germany and other north European creditor countries make any early action difficult. Lawmakers in those countries are insisting private sector bondholders must participate in any new funding for Greece.

The inability of European authorities to agree how to make banks and insurers share the pain of a second Greek pacakge without triggering a default has fueled speculation against the debt of other peripheral euro area states.

"We are shooting ourselves in the foot," a European central banker said, warning that any move that cast doubt on the absolute solidity of European debt would cause a massive loss of confidence.

ESSENTIAL ELEMENTS

EU policymakers and economists say essential elements in a new package for Greece should include a bond buy-back by the euro zone rescue fund, new official funding to keep Athens out of the capital markets until 2015 at least, and measures to guarantee Greek bank deposits and avert a possible bank run.

The interest rate on official loans to Greece, Ireland and Portugal would be cut to nearer the euro zone's borrowing rate and maturities would be further stretched out.

A buy-back would enable hedge funds and asset management companies to sell their Greek bonds at a discount, putting a floor under prices while enabling Athens to reduce its debt service bill and easing redemption humps in 2012 and 2014.

That would buy time to prepare for an orderly restructuring of Greek debt once the country is generating a primary budget surplus and its banks are better capitalized.

Policymakers and economists, speaking on condition of anonymity, say Greece's 345 billion euro debt mountain needs to be roughly halved to 80 percent of gross domestic product to be sustainable in the longer term.

Recent talk by some senior Berlin politicians of the inevitability of a Greek debt restructuring, and of contingency planning for a default, has rattled investors.

Italy has been hit both by domestic political instability and speculative trades on the possible breakup of the euro, the Credit Suisse economists said.

Investors began dumping Italian stocks and bonds last week amid fears that Prime Minister Silvio Berlusconi was trying to undermine and perhaps force out Finance Minister Giulio Tremonti, seen as the guarantor of fiscal prudence.

Italy's borrowing requirement for the next three years is more than 600 billion euros, dwarfing the euro zone's 450 billion euro rescue fund (EFSF), some of which has already been committed to the three smaller countries under assistance.

NAB economist Tom Vosa told Reuters Insider TV that Europe would need to quadruple the size of the current bailout mechanism if it needed to support Italy.

That would force a shrinking number of creditor countries to commit more capital and guarantees, which seems politically improbable.

FISCAL INTEGRATION

So if Italy came under more burning pressure, euro zone leaders would have to reconsider more radical options for fiscal integration which Germany and its allies have so far rejected. Otherwise, the euro area would risk breaking up.

European Central Bank policymaker Lorenzo Bini Smaghi suggested at a weekend conference in Greece that euro zone countries should hand over their debt-issuing powers to Brussels and drop the unanimity rule on bailouts.

The European Commission would enforce a ceiling on member states' borrowing, and issue debt on their behalf, he said.

Many euro area states would bristle at the idea of a centrally imposed debt brake unless there were big benefits in terms of cheaper borrowing.

Bini Smaghi said he was not calling for full political union or for bonds to be underwritten jointly by euro zone countries.

Luxembourg Prime Minister Jean-Claude Juncker and Italy's Tremonti have called for jointly guaranteed eurobonds, but Germany has so far ruled that out both as a breach of EU treaty rules and because it could raise Berlin's cost of borrowing.

European officials are nevertheless continuing to work quietly on the idea, with the European Parliament expected to formally request a proposal from the EU executive on the issue later this year.

One option would involve a joint guarantee of interest payments on nationally issued euro bonds up to an agreed limit, which EU lawyers say would not violate the treaty.

However, such a long-term solution would require years of political debate and persuasion. It is hard to see how it could be implemented in time to fight the current fire.

(editing by Janet McBride)