The warnings are coming fast and thick. Fitch Ratings has issue a red alert, deeming Italy’s insurgent government a threat to market stability and sovereign solvency.
The conservative leader in the European Parliament, Manfred Weber, said Italians are “playing with fire” as anti-euro Lega nationalists and the alt-Left Five Star Movement join forces to smash the euro austerity regime - and to deport 500,000 illegal immigrants. “This could provoke another eurozone crisis,” he said.
France’s finance minister warns of a “Greek-like” disaster if the new government goes ahead with plans for a flat tax (15pc and 20pc), a monthly €780 basic income for the poor, a reversal of pension reform and a VAT rise, and a “minibot” parallel currency that subverts the monetary control of the European Central Bank.
Citigroup estimates that these measures will cost 6pc of GDP, pushing the budget deficit towards double digits. The Lega-Grillini rebels aim to overthrow the new banking and bail-in rules, and halt the privatisation of Monte dei Paschi di Siena. They will ignore EU state aid rules for Alitalia and the steel industry. It is a total revolt.
The bond markets have woken up to the enormity of what is happening a country that cannot be easily crushed into submission “à la Grecque”, and that is big enough to destroy monetary union.
Risk spreads on Italian 10-year debt have jumped 65 basis points to 189 over the last three weeks. The worry has begun spreading to Spanish and Portuguese debt, a belated recognition that a euro rupture in Italy plausibly could not be contained.
“Nobody has anything to fear from our economic policies,” said Lega strongman, Matteo Salvini, who prides himself on nonchalant defiance of market theatrics. Soaring growth will bring down the debt ratio though the magic of the denominator effect - he said - with help from the Laffer Curve.
The drama in the bond markets is still symbolic at this stage. Italy has ‘prefunded’ much of its borrowing requirement for this year. The European Central Bank is still mopping up much of Italy’s debt issuance through quantitative easing. The problem arises at the end of the year when the ECB turns off the QE spigot.
At that moment, Italy will no longer have a lender of last resort standing behind it. The country will be nakedly exposed to market forces again. A rescue will be available only if the country activates a formal bail-out (ESM-OMT) under draconian conditions, requiring a vote in the German Bundestag and Dutch Tweede Kamer.
There is zero possibility that the Lega and ‘Grillini’ would accept the terms. They would start to activate the parallel currency and set in motion a withdrawal from monetary union, restoring full sovereign control over the Bank of Italy and the Italian commercial banking system.
Leader of the Italy's populist Five Star Movement, Luigi Di Maio (L), shakes hands with Italian lawyer Giuseppe Conte, as Di Maio presents his would-be cabinet team
The EU-Italy showdown over spending plans is likely to come to ahead long before that. Claudio Borghi, the Lega economics chief, said threats from Berlin to cut off central bank liquidity and Target2 payments to Italy are very dangerous for Germany. The Bundesbank’s Target2 credits to the ECB system - mostly to Italy and Spain - are €927bn and rising.
“If they really want to play hardball, it will backfire. Germany is the creditor of Target2, not us, and it is they who will suffer the losses if we default. I would urge a little bit of caution,” he told the Telegraph.
“If anybody in Europe thinks they can push up the bond spreads and that we will be ousted, they are very wrong. We have been through all this before with Mario Monti in 2011. Everybody in Italy understands that political manipulation of the spreads is the way they enforce their austerity on us. We are going to have a very frank discussion with the EU,” he said.
The new government was at last taking shape last night. The compromise pick for prime minister, Giuseppe Conte, is an unknown lawyer with no political experience. If accepted by President Sergio Mattarella, he will be a figurehead.
Power resides with the Lega’s Salvini and the hydra-headed Five Star led by Luigi di Maio. They plan a special body made up of the two parties to resolve disputes, arguably outside Italy’s constitutional structure.
Paulo Savona, the scourge of the Maastricht Treaty and the ‘German euro', looks poised to take charge of the finance ministry. A former minister from the 1990s - well-known in European capitals - he is in one sense a safe pair of hands.
But he long ago concluded that monetary union has trapped Italy in a bad equilibrium. “The country is being pushed deeper into economic under-development,” he wrote during the crisis 2011.
He called at the time for a “Plan B” to leave the euro. “Accords that are badly constructed or signed by countries with hegemonic intentions do not last long,” he said. This is not a man likely to succumb meekly to EU demands at the first sign of pressure. He is in any case bound by the terms of Lega-Grillini “contract for government”.
Senator Alberto Bagnai, a Lega senator and a key economic strategist, said the new government will press ahead quickly with the minibot scrip currency to cover €70bn of state arrears to contractors and households. “We aim to start within a year and possibly as soon as this year. There are many companies in deep financial distress,” he said.
“The minibots have huge political appeal. People want them, and they will have them. If the EU says we can’t do it, we will do it anyway. France has been violating the fiscal rule for the last 10 years,” he said.
“If Germany or the EU authorities try to blackmail Italy, this will fuel nationalist resentment and people will vote for us massively. They are already very angry,” he said. The latest polls suggest that anti-EU populist forces would win a bigger landslide in a snap election.
The EU will have to tread with great care. It is already facing twin crises over Brexit and the authoritarian lurch in Eastern Europe. It risks a strategic rift with the US. Europe may have to go along with more of what the Lega-Grillini are demanding than it lets on. “The appetite for a clash in Brussels is pretty much zero,” said Lorenzo Codogno, the former chief economist of the Italian treasury and now at LC Macro Advisors.
Italy is entering a maelstrom of two powerful and opposing currents. On the one hand, net fiscal stimulus of 2pc or 3pc of GDP implies a surge in economic growth as slack is used up and the output gap is closed. On the other, surging bond yields and capital flight hint an almighty crisis for a country with a public debt of 132pc of GDP.
It is far from clear which these conflicting stories prevails over the next two years. What is certain is that the EU cannot risk making any more mistakes.