(c) 2013, Bloomberg News.

(c) 2013, Bloomberg News.

BERLIN Italian government instability following the tax-fraud conviction of former Prime Minister Silvio Berlusconi threatens to end a lull in the European debt crisis and derail a nascent economic recovery.

Berlusconi's party has rallied around its leader, possibly seeking a presidential pardon and threatening a mass resignation of deputies in parliament, a move that could bring down Prime Minister Enrico Letta's government. Letta has told allies that he would quit before being pushed out if support dwindles, Italian daily la Repubblica reported on Aug. 3.

"If we decide together to do it, then I'm ready," Lucio Malan, a senator with Berlusconi's People of Liberty party, or PDL, said on Aug. 2 of a parliamentary walkout.

With the debt crisis on hold in anticipation of next month's German election, the rupture in Rome could stall efforts by Letta's fragile coalition to kick-start economic growth in the euro area's third-largest economy. Along with a corruption scandal involving the Spanish government, the instability comes as a European revival may be taking hold.

"As signs of economic recovery in the eurozone start to emerge, the political climate is deteriorating markedly," Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, wrote in a note to clients Sunday. "From an economic standpoint, the instability couldn't be happening at a worse time."

Letta will meet with Bank of Italy Governor Ignazio Visco and Finance Minister Fabrizio Saccomanni Monday in Rome, the premier's spokesman said. Visco is concerned turmoil could raise borrowing costs and make it harder to enact laws to stimulate the economy, Il Messaggero reported, without citing sources.

Markets so far have brushed off the tremors, opting to trade on the green shoots in the 17-member bloc. Italian and Spanish government bonds advanced for a third week after reports showed factory output in the euro area expanded for the first time in two years and unemployment in Germany declined.

Italian 10-year bond yields fell 3 basis points to 4.23 percent at 8:56 a.m. in Rome. Yields on similar maturity Spanish debt declined 2 basis points to 4.54 percent.

The PDL, the second-biggest bloc in Letta's coalition, held a rally in front of the former leader's home in Rome late Sunday. Berlusconi, insisting that the gathering was not "subversive," said the government must continue with its reforms.

"No one can tell us we are irresponsible," Berlusconi said. Letta last week downplayed the threat to his government of Berlusconi's conviction and said he hoped that "collective interests prevail for the good of the country."

Berlusconi, 76, was convicted of fraud linked to tax evasion in the purchase of U.S. film rights for the ex-premier's broadcast company Mediaset SpA. The ruling to uphold the conviction by Italy's highest court on Aug. 1 may lead to his expulsion from parliament.

The former premier and billionaire has denied all wrongdoing, saying the trials are motivated by prosecutors and judges out to destroy him politically.

After rescuing his makeshift coalition last month following a spat over a deportation scandal, Letta will have to overcome increasing divisions as he seeks to reduce an unpopular property tax and avoid a value-added tax increase.

Those proposals, which would ease austerity measures put in place by his predecessor, Mario Monti, must also match promises to hold Italy's budget deficit below 3 percent of output.

In Spain, Prime Minister Mariano Rajoy last week defended himself in parliament against demands that he resign. The leader has been buffeted by a party-payment scandal that's wiped out his lead in polls and cast doubt over his government's ability to overhaul Spain's economy.

Rajoy denied any wrongdoing, telling parliament in an extraordinary session in Madrid on Aug. 1 that he'd "made a mistake in continuing to trust someone who we now know didn't merit it." He was referring to the former treasurer of his People's Party, Luis Barcenas, who has named Rajoy among officials who allegedly received payments from a secret fund.

The ructions from Rome and Madrid come as the unemployment rate for the euro area held steady at 12.1 percent. Along with manufacturing output that unexpectedly expanded for the first time in two years and improving business confidence, signs gathered that the bloc is emerging from its longest-ever recession.

After contracting for a record six quarters, the euro economy probably stagnated in the three months through June and will grow again this quarter, economists predict.

_ With assistance from Andrew Frye in Rome, Esteban Duarte in Madrid and Tommaso Ebhardt in Milan.