By Philip Pullella and Emelia Sithole-Matarise
Italian 10-year bond yields shot above the 7 percent level that is widely deemed unsustainable, reflecting investors' concerns that they may not get their money back, prompting German Chancellor Angela Merkel to issue a call to arms.
Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait.
She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.
Portugal and Ireland were forced to seek EU-IMF bailouts when their borrowing costs reached similar levels and clearing house LCH.Clearnet sounded another alarm by increasing the margin it demands on debt from the euro zone's third largest economy, effectively raising the cost of holding Italian bonds.
The European Central Bank, the only effective bulwark against market attacks, wasted no time intervening to buy Italian bonds in large amounts.
"The ECB is buying aggressively," one trader said.
Italy has replaced Greece at the center of the euro zone debt crisis and is on the cusp of requiring a bailout that Europe cannot afford to give. Unlike Greece, an Italian default would threaten the entire euro project.
Having lost his majority in a key parliamentary vote, Berlusconi confirmed he would resign after implementing urgent economic reforms demanded by the European Union, and said Italy must then hold an election in which he would not stand.
He opposed any form of transitional or unity government -- which the opposition and many in the markets favor -- and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.
"It is a step in the right direction," Swedish Finance Minister Anders Borg said when asked about Berlusconi's plan to resign. "There has been no proper understanding of the problems being faced in Italy."
Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.
"There is no guarantee (Berlusconi's) successor will be able to do a better job. Just keep your eyes on the Italian yield for now," Christian Jimenez, fund manager and president of Diamant Bleu Gestion, said.
While Italian bonds blew out, worries that the debt crisis could be infiltrating the core of the euro zone were reflected in the spread of 10-year French government bonds over their German equivalent blowing out to a euro era high around 140 basis points.
Policymakers outside the euro area kept up pressure for more decisive action to stop the crisis spreading.
"Our sense is that if we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand ... we could run the risk of what some commentators are already calling the lost decade."
Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.
Euro zone finance ministers agreed on Monday on a roadmap for leveraging the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.
But there are doubts about the efficacy of those complex plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.
Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.
Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence.
German central bank chief Jens Weidmann, a key member of the ECB, rejected a separate proposal to use national gold and currency reserves or IMF special drawing rights to boost the bailout fund, welcoming opposition from Merkel to the same.
But with the ECB just about the only buyer of Italian bonds, according to traders, it will have to act more aggressively to contain the latest wave of crisis, despite internal opposition to its bond-buying program.
With the markets' fire turned firmly on Italy, Greece's struggle to find a new prime minister became something of a sideshow, but one which demonstrated the difficulty in taking decisive action anywhere within the euro zone.
Greek political leaders scrambled to agree on a new premier to lead the country back from the brink of bankruptcy, after a plan to name a former ECB official appeared to fall apart.
The aim is to establish a "100-day" government to push a 130 billion euro bailout plan, including a "voluntary" 50 percent writedown on Greece's debt to private sector bondholders, through parliament by February.
The socialist and conservative parties had wanted former ECB vice-president Lucas Papademos to lead a government of national unity but he appears to have made demands about his level of influence which they could not swallow.
(Additional reporting by Renee Maltezou and Angeliki Koutantou in Athens, Kirsten Donovan and William James in London, writing by Mike Peacock; editing by Janet McBride)