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ATHENS/ROME (Reuters) - Italian government bond yields soared to near 15-year highs, putting the euro zone's third largest economy front and center of the region's debt crisis, despite scrambling efforts by policymakers to stem the growing contagion.
Italy, the world's eighth largest economy, overtook Greece as the prime threat to the stability of the 17-country single currency zone, as finance ministers met to try to find ways of building a firewall around the two-year-old crisis.
Italian 10-year bond yields rose to their highest since 1997 -- approaching levels regarded as unsustainable -- with political turmoil in Rome threatening to drag a fourth European economy after Greece, Ireland and Portugal into the debt mire.
Jean-Claude Juncker, the chairman of Eurogroup finance ministers, said the European Central Bank would take part in monitoring Italy's promised economic reforms along with the European Commission and the International Monetary Fund, effectively putting the country under full surveillance.
Greece's outgoing socialist prime minister and conservative opposition leader rushed to put in place an interim national unity government for just long enough to save their country from imminent default by implementing a new bailout program.
France announced new austerity measures designed to preserve its wobbly AAA credit rating, without which the euro zone might no longer be able to bail out its weakest members.
In Brussels, euro zone finance ministers agreed a detailed mandate to scale up the currency zone's rescue fund by the end of November to shield vulnerable but solvent economies such as Italy's and Spain's from a possible Greek default.
In Rome, Prime Minister Silvio Berlusconi defied huge pressure to resign as he struggled to hold a crumbling center-right coalition together after being forced to accept intrusive IMF surveillance of his economic reforms.
Political sources said leaders of Berlusconi's PDL party had urged him to resign late on Sunday but he was resisting.
Juncker stopped short of calling for a national unity government in Italy, saying it wasn't under EU/IMF protection.
"What we are expecting from Italy is that Italy will implement all the measures which have been announced in Silvio Berlusconi's letter," he said after the finance ministers' meeting, referring to a letter sent last month that set out plans for pensions reform and deregulation.
Stocks fell worldwide on the uncertainty, but Italian shares ended higher, partly on hopes that Berlusconi could soon be gone, traders said.
A cabinet minister said Italy would face early elections if party rebels stripped Berlusconi of his majority in a crunch vote on public finances in parliament on Tuesday.
"If we have the majority we'll carry on, otherwise there'll be elections," Gianfranco Rotondi, a minister without portfolio, said after meeting Berlusconi at his Milan home.
Former European Central Bank vice-president Lucas Papademos was on his way to Athens, tipped to head a transitional Greek cabinet charged with pushing a 130 billion-euro ($170 billion) bailout plan through parliament to secure a crucial 8 billion-euro aid tranche before early general elections in February.
A Greek government spokesman said talks on finding a new prime minister were continuing in a good spirit, indicating no decision had been reached. The Greek cabinet will convene at 5 a.m. ET on Tuesday to discuss developments.
A senior opposition source said Finance Minister Evangelos Venizelos and his top economic team would stay for continuity.
Whoever leads the temporary Greek administration will face a monumental task in restoring order to a country of 11 million whose chaotic economy and politics are shaking international confidence in the entire euro project.
In Paris, President Nicolas Sarkozy's center-right government announced a new wave of austerity measures, bringing forward a rise in the retirement age, raising some taxes and de-coupling welfare benefits from inflation, in a drive to cling on to France's top-notch credit rating.
The package designed to save 18.6 billion euros in 2012 and 2013 inflicted further pain on voters six months before Sarkozy is expected to seek re-election against a resurgent Socialist opposition, whose candidate, Francois Hollande, is far ahead of him in opinion polls.
Prime Minister Francois Fillon said French public finances had been in the red for 30 years and the time had come to break with the damaging habit of spending beyond its means.
"We've got to pull out of this dangerous spiral," he told a news conference.
As finance ministers of the euro area conferred on Greece and ways of strengthening their financial firewall, one euro zone official said: "We exhausted our scope for concern with Greece. The main concern of the ministers now is Italy and the leveraging of the EFSF."
Euro zone leaders agreed last month to scale up the European Financial Stability Facility's firepower to around 1 trillion euros by offering first loss guarantees on new bond issues, and attracting foreign investors through a special purpose vehicle with credit enhancements.
Europe's top economic official, Olli Rehn, said that while the European Commission had to be ready for all eventualities, there was no study being conducted on how a country could leave the euro zone, which is not foreseen in the EU treaty.
"We want to ensure that Greece can and will stay in the euro," he told the European Parliament.
Until the new firefighting tools are ready -- perhaps not until next month -- the task of trying to prevent a bond market meltdown that could leave bigger euro zone economies needing rescuing falls to the European Central Bank.
The ECB disclosed on Monday that it had stepped up purchases of euro zone government bonds, presumed to be mostly Italian, buying 9 billion euros last week in the first few days in office of new ECB President Mario Draghi.
But the bond-buying, which prompted the two most senior German ECB policymakers to resign this year, failed to stop Italian spreads over safe-haven German Bunds hitting a euro lifetime high due to the deepening political instability.
Another row between the guardians of German central bank orthodoxy and euro zone financial firefighters burst into the open when the German government was forced to deny reports that it had sought to tap the Bundesbank's gold reserves.
Several G20 sources said leaders of the world's major economies had discussed at a summit in Cannes last week the possibility of euro zone countries pooling their borrowing rights at the International Monetary Fund to provide greater leverage for the EFSF. The Bundesbank holds Germany's Special Drawing Rights, secured by its gold reserves.
German sources said the proposal had caused tension between Bundesbank President Jens Weidmann and Finance Minister Schaeuble, as well as between Weidmann and the ECB.
"German gold reserves must remain untouchable," Economy Minister Philipp Roesler said when asked about the issue. The Bundesbank and a spokesman for Chancellor Angela Merkel also ruled out the idea.
Additional reporting by Ana Nicolaci da Costa in London, Gavin Jones and Barry Moody in Rome, Brian Love and Vicky Buffery in Paris, Jan Strupczewski, Ilona Wissenbach and John O'Donnell in Brussels, Harry Papachristou and Ingrid Melander in Athens, Ritsuko Ando and Terhi Kinnunen in Tampere; Writing by Paul Taylor and Luke Baker; Editing by Peter Graff