The Battle of Spain is over; the Battle of Italy has begun.This morning we noted the first signs of falling confidence just hours after Europe’s announced $125 billion bailout of the Spanish banking system. By late this afternoon the news is all about fears that Italy will be next in line.A Spanish collapse tests Europe; an Italian collapse could break it. That crash could come quickly. Despite the strengths of its economy — a solid manufacturing base, an inventive entrepreneurial class, famous brands and low budget deficits — things could get very ugly very fast in Italy. Italian households can be brutally realistic and unsentimental about saving their nest eggs. Nobody wants to be the last idiot left with money in an Italian bank if trouble really comes. Few Italians define ‘patriotism’ as being a sucker; look for the euros to come out of the banks very fast if rumors spread or panic grows.But if an Italian crisis has become easy to imagine, a solution to the crisis is harder to see. Italy’s economy is so big, and its debt so large, that even the wealth of Germany and the other solvent states will be hard pressed to fund a bailout.Worse, an Italian bailout will be hard to arrange — and it will be harder still to enforce the terms once the money is paid.Remember this: the Greeks hoped that they could blackmail Europe with the threat of “mutually assured destruction.” They tried to play chicken, hoping that the EU would be so frightened by the specter of a Greek collapse that Greece could win substantially better terms by threatening to walk away.But Greece is too small, and the rest of the Europeans had spent enough time preparing to weather the storm from a “Grexit” — a Greek exit from the eurozone. As a result, the Greek threats are sounding hollow and Greece is left without much room to maneuver.Spain tried the same thing, and had much better luck. Spain is bigger, and the threat is more credible. Also, Spain did not have Greece’s long record of lies and broken commitments. Spain so far has had much more success in negotiating a bailout rather than accepting dictation.Italy is bigger than Spain, and its diplomats are wily and good at brinkmanship. Italy is almost certain to play hardball if the skies continue to darken and a bailout begins to look needed. Italians are realists, and as they see it, the reality is that Germany will suffer as more or much from an Italian meltdown as Italy would. Don’t look for Italy to take less than full advantage of any assets it has.Italy is also clever and inventive; look for Italy to figure out surprising ways to look as if it is extremely busy and intent on a reform process while very little actually happens. This is all the more likely because the Italian state probably can’t deliver on the reforms Germany and its allies want. Orders can be given by ministers and effectively sabotaged by lifetime bureaucrats who know how to say ‘yes’ while doing ‘no’.Even the threat of an Italian collapse will drive profound change and, likely, push Europe to the kind of decisive action (towards either a full fiscal union or a break up of the euro zone) that it has so far managed to avoid. Italy is one of the founding members of what grew into the European Union and the EU’s most important founding document in many ways is the 1957 Treaty of Rome. There is no way that Italy can be seen as part of Europe’s periphery. It is part of the core, and it is looking more and more as if Italy will present Europe with its greatest test and perhaps its defining moment.The Battle of Italy is truly under way; the Battle of Europe comes next.[Tuesday update: From the Financial Times: Spanish bonds fall to new euro-era lows and Italian bonds are also under pressure.