Italy is in trouble. This is why the world should worry about it.

The European Union sent the Italian budget back to Rome with a failing grade. Italian bonds are being bludgeoned on the financial markets. Italy's credit rating is dangerously close to junk status.

Bond operators and European politicians should worry about such things. But do they really matter to ordinary Italians and the rest of the world?

Unfortunately yes. Disastrous consequences can occur when interest rates soar and investors lose confidence in a country's ability to repay its debts.

That's what happens. On Friday, Moody's Investors Service lowered the Italian debt rating to a notch above the level where it would no longer be considered premium – in common jargon.

Given the tension between the Italian populist government and the European Commission, Standard & Poor's will follow Moody's initiative on Friday, urging Fitch and DBRS to do the same.

Italy probably has several months to avoid slipping on the cliff to the abyss of junks. This could indicate a willingness to compromise with Brussels, or perhaps the government's spending plans go against the forecasts and, as promised, revive the economy. But if Italy suffered another downgrade, it could result in a chain reaction that would be difficult to control for governments and central banks.

Here is an overview of what could happen in the worst case.

Italian banks start to flicker

The big Italian lenders have been beaten in the last 10 years and are already weak. All have large stocks of Italian government bonds. If this debt loses value, as after the damage, the banks will suffer losses and erode their capital.

Banks could then lose the confidence of the financial markets, investors fearing for their solvency. All banks depend on a constant flow of borrowed money that they lend to their clients or that they use to refinance their debts. If this lack of liquidity dries up – an alleged liquidity crisis – banks can quickly find themselves in trouble. This happened massively for banks in Europe and the United States during the 2008 financial crisis.

Italian banks have thicker capital buffers than during this financial crisis, a report from Deutsche Bank said Tuesday, but "liquidity still represents a risk".

When euro-zone banks are rejected by the market, they can turn to the European Central Bank. But that raises another problem.

European Central Bank cuts support

Eurozone banks can borrow as much as they want from the zero-rated central bank, but there is a problem. They must put in place guarantees. One of the most common forms of collateral is, would you not know, government bonds.

If these bonds are rated undesirable by the four rating agencies, the European Central Bank no longer accepts them. This is what happened to Greek banks when Greek state bonds fell to junk status, which caused severe economic difficulties.

Banks can play other collateral, such as bonds of more solvent countries or corporate debts. But experience shows that distressed banks generally lack other assets. They can still borrow money from the central bank, but at much higher interest rates, which puts them at a competitive disadvantage.

The European Central Bank has a separate program allowing it to buy Italian bonds on the open market, thus helping to limit the country's borrowing costs. But Italy would only be eligible if it accepted conditions that would certainly include spending limits, which the populist government is unlikely to accept.

Italy suffers from credit crunch and enters into recession

Banks' difficulties are becoming a daily problem as businesses and consumers can no longer obtain credit. They spend less and growth slows down. In the case of Italy, the overburdened government would not be able to pay bank bailouts. (One of the reasons why Italy is so heavily indebted, is that it has already spent huge sums to save its banks.)

When people spend and earn less, they pay less taxes. Government revenues are declining, Rome's ability to repay its debt is suffering and a vicious circle is being created, difficult to stop at the country's borders.

The woes of Italy are spreading around the world

Economists are questioning whether Italy could provoke another major financial crisis. Some experts say the financial system has become stronger since 2010, when Greece's debt problems had almost destroyed the eurozone.

"The core of the financial system is much more resilient than before the global financial crisis, with increased bank capital and liquidity," said the president. The Financial Stability Board, a group of central bankers, regulators and government officials trying to keep an eye on impending crises, said Monday in a statement.