* President alarmed by Italian bond yields
* Says no doubt about Berlusconi resignation
* Says new government or election called quickly
By Barry Moody
ROME, Nov 9 (Reuters) - Italy's president stepped in to try to calm markets on Wednesday after the country's borrowing costs raced to catastrophic levels, saying urgent action would be taken to end a political crisis.
Head of state Giorgio Napolitano, expressing alarm about a collapse in market confidence, said there was no doubt about the resignation of Prime Minister Silvio Berlusconi once economic reforms were implemented by parliament within days.
When a financial stability law incorporating the reforms promised to European leaders was approved, Napolitano said he would rapidly hold consultations to end the crisis.
"Therefore, within a short time either a new government will be formed ... or parliament will be dissolved to immediately begin an electoral campaign," Napolitano said.
The president, who has played an increasingly active role in the crisis, said he had been obliged to issue his statement because of the pressure on government bonds, whose yields shot above a "red line" of 7 percent on Wednesday.
In a possible sign that he was preparing the way for a so-called "technical government" led by an independent outsider, Napolitano named former European Commissioner Mario Monti as senator for life.
Monti has been widely seen as the most likely leader of a government of technocrats to implement vital economic reforms and steer Italy through to new elections in 2013.
Markets have been clamouring for weeks for Berlusconi to depart because of his failure to push through painful austerity measures and disarray from a rebellion inside his own party.
But the 75-year-old media tycoon's pledge on Tuesday night to step down once vital economic reforms are passed instead accelerated the crisis at the centre of the euro zone, with markets unnerved by the unorthodox postponement of his resignation and fears of extended political uncertainty.
Analysts said Italy was now in territory where Greece, Ireland and Portugal were forced to seek bailouts.
Berlusconi's insistence that the only way out was elections early next year, and deep political disagreement about the next move, only worsened the uncertainty, although two factions in his own PDL party said on Wednesday they opposed early polls.
In another indication of how serious the crisis of confidence is, spreads between Italian government paper and German bunds rose over another watershed of 500 basis points, reaching a record above 560.
FORCE THE PACE
An election would put Italy in limbo for several months and there was no sign of agreement on the urgent formation of a transitional government that could calm markets, but Napolitano clearly intends to force the pace.
Other politicians on Wednesday finally seemed to realise the urgent need to restore market confidence. A parliamentary source said lower house speaker Gianfranco Fini intended to have the financial stability law approved by Sunday.
"Italy must regain credibility and confidence as a country for us first of all to get out from a very dangerous squeeze on financial markets," said Napolitano, an 86-year-old former communist who has gone to the limits of his traditional powers to combat the crisis.
Italy's centre-left opposition wants the urgent formation of a national unity government but its main leader, Pier Luigi Bersani, said this was unlikely because of resistance from the centre right. He believed elections were likely.
Berlusconi and his closest allies say a government of national unity, including the left, or of technocrats, would be an undemocratic "coup" against the last election in 2008.
But a significant number of PDL deputies appear to oppose elections.
They fear the centre-left victory predicted by opinion polls after Berlusconi's popularity slumped because of a string of sex and legal scandals, political errors and above all the pressure from foreign markets.
Analysts say one consequence of the crisis could be the collapse of Berlusconi's PDL as centrist parties try to woo its disgruntled members.
Berlusconi said that PDL party secretary and former justice minister Angelino Alfano, long his anointed successor, would be the centre right's candidate for prime minister.
"I will resign as soon as the (budget) law is passed and, since I believe there is no other majority possible, I see elections being held at the beginning of February and I will not be a candidate in them," he told La Stampa newspaper.
Italy is in the eye of the euro zone debt storm because, as the region's third largest economy, it is viewed as too big to bail out. Its crisis therefore poses a real threat to the survival of the single currency.
Despite the new sense of urgency fuelled by Wednesday's debacle in the markets, there are still wide disagreements both about the form of a new government and on budget and structural reforms to bring down Italy's huge debt and revive its long-stagnant growth.
One small opposition group, the Italy of Values party, said on Wednesday it would vote against the reforms.
EU inspectors were in Rome on Wednesday to begin a monitoring mission aimed at ensuring economic reforms are carried out as part of an agreement reached at a G20 summit last week. Most of the reforms are incorporated in the budget measures to be voted on by parliament.
The European Commission sent a letter to Italy this week requesting more details on the reforms and saying additional measures would be needed to meet the target of balancing the budget by 2013.