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The biggest chair in the world stands seven stories tall, weighs almost 23 tons and is found just to the left of the second traffic light in the tiny town of Manzano (population: 7,000) in the north-eastern corner of Italy near the Slovenian border. The red pine monument is not some avant-garde artistic statement. It's an oversized acknowledgement by the local business community of the industry that brought immense prosperity to Manzano and 10 small communities around it over the past half-century. Known as the "chair triangle," this district every year produces up to 40 million chairs of all shapes and sizes—especially but not exclusively out of beech and oak wood—for offices, homes, hotels, cruise ships, hospitals and restaurants around the world. Locals like to boast that the district in its heyday made one in every three chairs sold worldwide. The demand provided ample work for a tight-knit network of 1,100 highly specialized artisans and small firms. And it transformed this once modest rural area into one of Italy's richest and most dynamic commercial zones, a district with virtually full employment and a chronic shortage of skilled labor. "We were the China of Europe," boasts Giulio Fanin, an entrepreneur who makes machine tools for chair manufacturers.

But these days, the real China is making Manzano's prosperity as precarious as a two-legged stool. In a perfect example of globalization at work, ferocious competition from Chinese manufacturers is snatching away Manzano's customers. Over the past three years, about 200 Manzano companies have closed and a worrying number of the remaining 900 are struggling. Sawmills have moved to Croatia, Poland and Romania, where an increasing amount of initial pre-fabrication is being carried out. Manzano's once dominant share of the market for no-frills office swivel chairs has almost entirely collapsed because Chinese producers can churn them out at almost the same quality for a fraction of the cost. Now the Chinese are starting to attack the market for residential and other chairs, not just basic models in metal and plastic but more sophisticated ones in wood and leather, too. Talk about "the crisis" is ubiquitous in Manzano—even the executives of thriving companies say they worry that the unique industrial fabric of the area is fraying. "We see people with tears in their eyes not knowing what to do next," says Simone Focacci, manager of one of Manzano's three principal banks.

Valerio and Lucio Minin are two of those shedding tears. During the 1990s, the company their father founded half a century ago, Mininsedie, produced up to 500,000 chairs annually. But this year Mininsedie will make just 130,000—many of those stacked and waiting for buyers in a cavernous warehouse that serves as the firm's headquarters. The French distributor who was their biggest customer is out of business. Revenues have declined by 50% in two years and, with losses mounting, the Minin brothers recently laid off five of their 15 employees. "The situation here is tragic," says Valerio, 51. "I just don't know how we're going to continue. You keep banging your head against the wall and either the wall falls—or you do."

Italy is the sick man of Europe these days—its economy has shrunk by 4% since 1999 after adjusting for inflation—and the predicament of the chair triangle helps to explain why. Along with Germany and France, the nation has been struggling with weak consumer spending, waning productivity and rising government deficits. But unlike its neighbors, Italy lacks robust large corporations that can export their way out of trouble. Many of the thousands of small and medium-sized companies that once gave the Italian economy its flexibility and dynamism are poorly equipped to deal with the challenges of a fast-changing world. Most don't have the scale, the funding or the commercial know-how to become global players. What they produce is beautiful, but it's neither particularly sophisticated nor difficult to replicate. In other words, Italy's economic structure is almost perfectly shaped for an attack by China, which excels in moderately sophisticated manufacturing—and can turn out products far cheaper than is possible in western Europe. In sector after sector—from textiles to shoes to furniture—companies have been losing ground.

When Italian manufacturers ran into competitive problems in the past, there used to be an easy fix: currency devaluation, which made Italian exports cheaper relative to those of other countries. But that solution is no longer a panacea, because Italy swapped the lira for the euro, which has risen against most other currencies. "We used to say small is beautiful, but that's no longer true," says Adalberto Valduga, president of the regional chamber of commerce in nearby Udine, the provincial capital. While the strong euro is penalizing firms, he says the real challenge is a more fundamental one: "We need to change our way of thinking." The International Monetary Fund agrees. In a tough report last month, it castigated Italy's economic policies and said the nation's waning competitiveness was due to "deep-seated inefficiencies" as much as to foreign competition. China looks set to overtake Italy this year as the world's sixth-largest economy after several years of jockeying for the spot.

The Italy vs. China manufacturing battle has a significance that transcends national borders. If the Italians can find a way to carve out an upmarket niche for themselves—as the most successful chair manufacturers are attempting to do—there's every reason to believe that Europeans and Chinese can coexist and flourish, with each building on its respective strengths. Several Manzano entrepreneurs are already looking to China as a market where they can both buy and sell. "Nobody can stop the Chinese anymore," shrugs Lucio Zamò, one of the few remaining successful manufacturers of office chairs in the district. Zamò has been able to cut expenses by building chairs using imported Chinese aluminum bases, which cost 40% less than Italian ones. But should the Europeans prove unable to resist the fierce competition, politicians may try to level the playing field by imposing protectionist trade restrictions on Chinese imports. The European Union made a botched attempt to restrict imports of Chinese textiles this year and is now considering slapping tariffs on leather shoes.

But if Manzano is to recover its mojo, the chair triangle's entrepreneurs know that they—and not politicians—will be the ones to find it. "This is a moment of maturation," says Fanin, the machine-tool manufacturer, who recently laid off six of his 15 workers. "You can't compete on price. You need to believe in the company and innovate. There's no third way."

Manzano's claim to be the chair capital dates back centuries. An eighth-century altar in nearby Cividale contains the first trace of chairmaking. During the Renaissance, local carvers and carpenters from the region had their hands full with orders from Venice, 120 km away. Production of chairs for the masses began in the 1800s but the real boom came after World War II. Big distributors, primarily from Germany, discovered the local craftsmanship and started buying in bulk, turning Manzano chairs into a $1 billion-per-year business. To cope with the demand, the number of firms grew tenfold as highly specialized artisans set up on their own, supplying individual parts to their neighbors who would then work them into the next stage of the manufacturing process before passing that on to another firm. One artisan would just do leather upholstery, for example, or specialize in varnishes. This highly decentralized industrial structure, a type of extreme outsourcing network, is quite common in Italy. By one estimate there are about 100 such industrial clusters in the country, producing shoes, clothes and even some food products.

The flexibility of such clusters is sometimes held up as a model by experts on economic development such as Harvard Business School professor Michael E. Porter. But the system has proven vulnerable to an onslaught of international competition. About 90% of the firms in the district have fewer than 20 employees, while just a dozen have more than 50, according to a study by Professor Roberto Grandinetti of the University of Padua. Local bankers say that all but a few are sorely undercapitalized and lack the resources to build their business up to a global scale. And virtually nobody has much experience selling to customers other than the big German distributors who once snapped up as much as 70% of the district's output. "Twelve years ago, I began saying that it wasn't enough just to make chairs, but that we also needed to sell them," says Giovanni Masarotti, president of the Manzano chair district and chief executive of Montina, one of the oldest firms. "If I say three companies have true marketing departments, I'm exaggerating."

None of that seemed to matter until three years ago. Then a triple whammy hit the district: the rapid emergence of China, a rising euro and a rocky post-Sept. 11 economy that made buyers everywhere extremely price-conscious. American customers were the first to look east, but the all-important German distributors quickly followed suit. Suddenly, a business that had seemed steady and dependable turned out to be anything but. "Firms that were doing well in one quarter found their sales cut in half the next," says Focacci, the local banker. "One effect of globalization is that change comes very quickly."

It doesn't help that making chairs is not rocket science. Design has long been an Italian strength, but chairs are easily copied. Manzano's entrepreneurs often argued with one another about who originated new models, but now their quarrels have gone global. They complain that Chinese manufacturers are simply borrowing what they find in catalogs and on websites. The Italians insist they still have an edge when it comes to quality, especially with chairs made out of fine wood or upholstered in top-quality leather. While the Chinese are particularly good at mass-producing huge amounts of identical chairs cheaply, the Italians can tailor their production to far smaller and more specific needs. Masarotti, the district president, cites hotels as prime customers, because they often want relatively limited numbers of the same chair in a variety of colors. But even here the Chinese are muscling in. "We've lost the Japanese [hotel] market," Masarotti says. "We used to sell 2,000 to 3,000 chairs to equip an entire hotel, but now if we send 100 for the lobby and bar we're happy."

How can the Italians fight back? Alessandro Calligaris has a blunt answer: "We have to win the loyalty of our customers." He is 60, with a fuzz of white hair and a reputation as the most successful businessman in the chair triangle. His company, the eponymously named Calligaris, was started by his grandfather in 1923 and is still growing. Revenues last year rose by 12% to $140 million. His first big move, over a decade ago, was to figure out that the future lay in more than chairs. The Calligaris furnishing collection, sold under the slogan "Italian living," this year included sofas and beds for the first time, as well as shelves, tables and, of course, chairs. One big shift came in 2000 when the firm began buying and processing its wood in Croatia, at a plant near the forests where it's cut. Calligaris switched some of the upholstery work to Bosnia, where wages are a tenth of Italy's. And he's put a relentless focus on making his own branded products rather than manufacturing for other companies. In 1997, 35% of the firm's output was of no-name furniture. Today it's 1.5%. The firm's 12,000 clients include marquee names such as Bloomingdale's in the U.S., and Calligaris has just opened a subsidiary in Japan. But "we still need to invest more, to be closer to the market," he worries. One plan under consideration: establishing a worldwide franchising network.

"Everybody thought Calligaris was mad when he started, but now he is a model for all of us," says Gino Piani. He runs a company called Forsedia, which has 50 employees, three lines of furniture and slumping sales. Piani's answer is Calligaris-inspired: he is trying to create his own brand and sales network together with fellow entrepreneurs. Two of the four firms he hoped to team up with have since dropped out but Piani doesn't need to look very far to see that he needs to do something. A company called Sibau located just down the road from his factory collapsed in May, with the loss of 50 jobs. "They stayed still too long," Piani laments. "They thought nobody could make chairs the way they did."

The Manzano district as a whole is working on a strategy that it hopes will help all the chair manufacturers: it's trying to create a certified hallmark analogous to the one used by the ham producers of San Daniele, 20 km away. To qualify, chairs would have to be made locally and meet stringent quality standards. Each hallmarked chair would be numbered for authenticity. "The first thing we need to do in this global world is to have an identity. If we don't, we'll disappear," says Fabrizio Mansutti, president of Promosedia, a local trade association that is sponsoring the plan. While the hallmark is in its early days—only 15 firms have signed on—the sentiment behind it is widely endorsed. "We need to sell 'made in Italy,'" contends Luigi Cozzi. His firm, Idealsedia, once shipped low-end chairs to mass retailers including Target in the U.S., but it's now trying to go upmarket. For a while it used Chinese leather to cut costs but has switched back to Italian.

Yet even as they talk about focusing on Italy's strengths, officials for most of the bigger firms are shifting production out of the Manzano district. Cozzi, for example, has relocated his wood treatment to Romania, where Idealsedia now has 300 workers—50 more than it has in Italy. Such cost-cutting moves are a matter of survival for many. Natuzzi, a major Italian sofamaker headquartered in Santeramo, still manufactures its high-end products in Italy. But less expensive sofas aimed at price-conscious North American consumers are now made wholly at a factory Natuzzi operates in Shanghai. The company had no choice but to open a Chinese plant, says Daniele Tranchini, Natuzzi's chief global sales and marketing officer. "Half of our sales come from North America, and that market has been hit more than most with cheap products from China," Tranchini says. Besides, he adds, "Everyone recognizes it's an Italian product. Where it is manufactured has really become a secondary issue."

The shift eastwards is hastening the demise of the chair triangle. The Minin brothers, for example, formerly sold one type of chair that constituted about 10% of their output to Calligaris. But four years ago, Calligaris began making the same model itself, in Croatia. "The big firms are killing the little ones," gripes Valerio Minin. Pessimists in the chair triangle—and there are plenty these days—say perhaps 10 of the biggest firms will survive, each with a small network of suppliers, and that everyone else will go under. Piani of Forsedia reckons that about half of the firms still in business are in financial trouble and that a further 20% are heading into it.

That's too bleak an estimate, say the optimists. Luciano di Bernardo, managing director of a Cividale-based bank that is one of the key lenders to the district, even reckons that the worst of the crisis may be over. While chair exports continue to fall, he says bank-lending data shows that investment in the district is picking up quite strongly this year. About one in five firms is having difficulties and needs to change, he estimates, but the district as an industrial cluster does have a future, albeit in a different form. "The production can go wherever," di Bernardo says. "But there's an absolute need to keep the brains and the technology here." Italy can only hope that he's right.

• Peter Gumbel
• What happens when old-world craftsmanship collides with harsh new commercial realities? Welcome to Manzano, Italy's chair-production capital, as it is battered by cheaper Chinese rivals