"You come so close to getting it... yet then veer completely away from it... I dont understand."

Wow, I'll try to ignore the perplexing levels of arrogrance you've shown here. I know you think you know quite a bit about economics and, in fairness, you do get some of this stuff. Try being a little less cocky though, you're not nearly as well informed about this as you think you are, believe me.

Let's me offer some corrections to what you've said.

1) Without strict austerity (the whole point of this arguement) you can't say you have strict fiscal constraints with insistence on it being met.  The USA has strict budget rules about State budget deficits.  Yet the US acts as a "Lender of last resort" to the states.

What happens?  They don't tackle their budget problems.

Not quite sure if this point is serious. If you really believe the Federal Reserve has much to do with the US not being able to manage its budget deficits you're barking up the wrong tree. Congress during the presidencies of Clinton and Nixon (LBJ as well I think though I'm not sure, it's been a while since I studied that stuff) managed to produce small budget surpluses. US budget deficits have varied wildly over the years. The reason for this is the US political system is royaly screwed up. It has little to do with the Fed.

2) Europe doesn't have the money to bail out bigger countries anyway.  Europe has more money it can fork out, but not anywhere near enough to save a State like Italy. 

It depends for how long you're talking about. For a short period, perhaps one to three years or so, it could be managed, after that things would get a bit ropey. That's why you need regulations for fiscal responsibility to be introduced but it needs to be more gradually. Room for growth must be allowed. You take away all available credit straight away the downward spiral keeps going.

3) the ECB working as a lender of last resort would SEVERLY drain other countries, and likely push them over the edge as well.  France isn't as far away from being Italy as you'd think.

But it's a lot further from Italy than you think. A lot of the hoo-haa about France regards the exposure of its financial institutions to Greek, Irish, Spanish, and Italian debt. If you can convince the market that this debt won't be defaulted on then large chunks of France's problems go away. That's why they are so keen on the issuing of Eurobonds.

In short the truth is if you restore market confidence in the Eurozone, a lot of the problems get solved. I don't think anyone would dispute that. Market confidence does not get restored, however, if the market believes an Italian default can happen in the near future. So, how do you avert this?

1. You introduce measures which insist on fiscal responsibility. However, you do it at a gradual pace that allows some credit to circulate in the market and allow the chance for  domestic growth to occur. This measure, on its own, won't work though.

Why? Beacuse this doesn't alter the sobering reality that if Italy can't get enough credit on the market it automatically defaults. The ESM isn't enough to save it, even on any reasonable short term basis. The Eurozone as a whole, however, does have the cash to save it on a short term basis.

2. Therefore you must depoliticise the giving of emergency credit to Italy as much as possible by making the ECB a 'lender of last resort'. The market will then be confident enough that short term bonds will be honoured and so will be able to make credit available to Italy at a sustainable rate.

These two need to go hand in hand. It doesn't seem like one works without the other.

And kill the value of everyone's savings? Ouch that would make things worse for people, not better. 

Well Scandinavian countries are doing rather fine and we have free education, healthcare etc. You can have socialist market economy and still have goverment doing fine financially. Not to mention USA has just as high debt ratio as many European countries and you don't have any of these benefits.

It declares its current bonds worthless.  It means that the nation, if it ever needs to borrow again, has to pay a lot higher interest in the future.  In short, it says it isn't paying back the money it borrowed.