Although most of the euro zone’s attention in the last week has been fixed on the clash between the German constitutional court (the BVG) on one side and the European Central Bank (ECB) and European Court on the other (a conflict I wrote about here and here), that is a clash that — if the parties put their minds to it (and they may not) — can be resolved by agreeing not to talk about the underlying dispute and opting for a messy quick fix instead.

But the storm that is gathering over Italy — a storm that was somewhere in the mind of the BVG — cannot be so quickly wished away.

Writing two days ago for Bloomberg, Alessandra Migliaccio, Luca Casiraghi, and Viktoria Dendrinou provide a useful summary of some of the issues that are coming to a head, even if they do not address the underlying causes of Italy’s woes: It cheated its way into a currency union for which it was clearly always unsuited, and was always going to be unsuited. The result has been to place its economy into a straitjacket from which it has been unable to escape. Italy has been in and out of recession since 2000 and now its weakened, heavily indebted economy has to deal with the consequences of COVID-19 and the economic destruction caused by the effort to contain it.

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Bloomberg:

The European Commission sees gross domestic product shrinking 9.5% this year, after a 4.7% decline in the first quarter, the worst drop since the series started in 1995. That could swell its already massive debt to well over 150% of GDP.

And those are not the most pessimistic numbers out there.

Meanwhile, for now, Italy can afford its debt load.

Bloomberg:

The ECB has enabled Italy to keep servicing its giant 2.4 trillion-euro ($2.6 trillion) debt load affordably. While the cost of insuring against default rose in March to its highest since 2013, 10-year bonds still yield less than 2%. In 2011, they topped 7%. The government tapped the market again Wednesday, selling 9 billion euros in bonds.

Another difference from 2011 is that the politics are much more complicated. Unlike Greece, Italy has meaningful leverage: foreign investors hold more than 700 billion euros of its bonds, a third of the total, according to Bank of Italy data. Any problem there would be enough to send shock waves through global financial markets and Europe’s weakened banking system.

To that should be added the mayhem to the internal-financing arrangements of the Eurosystem, particularly Target-2, its payment mechanism, where Italy’s negative balance is currently a little under €500 billion. While there are those that dismiss Target-2 as an irrelevance, a book-entry that means nothing, if Italy has to leave the euro, that money is gone: There is no chance that Italy could repay it, particularly in a ‘new lira’ that would crash against the single currency.

And the chaos across the euro zone caused by an Italian exit would not stop there.

The threat that Italy might quit the currency union remains one of its biggest weapons: It is too big to sail.

And so, Bloomberg:

No one in Rome needed to hear the warning last week from the European Commission that the virus-spawned recession will be severe enough to put euro unity at risk. Like his forebears in 1992, Italian Prime Minister Giuseppe Conte felt abandoned by his allies early on in the pandemic when France and Germany ignored Italy’s cries for help. Italian opposition leader Matteo Salvini expresses sympathy for fans of a referendum on exiting that would tap into rising Italian frustration with the euro.

The wrangling was on display last week when euro-area finance chiefs approved a deal to provide ultra-cheap loans via its rescue fund, but without any onerous conditions. Yet the insistence by Italy’s populist opposition that such loans would undercut the country’s sovereignty has rendered them politically toxic — even if they would lead to greater savings. Along with France and Spain, Italy has been pushing the bloc for joint borrowing against opposition from the likes of Germany, the Netherlands and Austria.

This remains unacceptable to the ‘northern’ bloc (Finland should be added to its ranks), to whom such bond issuance is unacceptable in its own right and as a step along the road to a fiscal union that the ‘frugal four’ fear (quite rightly) would be a transfer union, draining their taxpayers in perpetuity, another fear at least partly reflected in the BVG’s judgment.

Intriguingly, the Bloomberg report also contains this:

Even without the German decision on the ECB, the risks of buying Italian debt were too great, said Patrice Gautry, an economist at Union Bancaire Privee, as he mused on worst-case outcomes. “A bold option would be for Italy and other Club Med countries to split from the euro zone, with different, looser rules on the debt side,” he says. “It was something already discussed with the Greek crisis.”

That is indeed the way to go. Splitting the euro into ‘northern’ and ‘southern’ units has long been the least bad way to fix the mess created by the belief that a ‘one size fits all’ currency would work for such a wildly disparate group of economies. Sadly and madly there appears to be no support for the idea amongst those that count, meaning that, in the end, the frugal four will at least concede some debt mutualization, although the form it takes may well now have to reflect the concerns of a watching BVG.

But if the frugal four do concede, it will not be until the last moment. If I had to guess (and that is all anyone can do), Italian yields are going to go up a lot — and by a lot, I mean a lot — higher before that last moment comes.