Italy's political crisis could have devastating effects on the European economy

The departure of Italy from the single currency would be a significant weakening of the eurozone, yet retaining Italy in the system under a regime of fiscal chaos would be hardly more palatable

There is a paradox at the centre of the Italian political crisis: what may be good for Italy, or at least would be popular in Italy, would be bad for Europe. As the effective guardian of the Italian constitution and of the country’s international obligations, President Sergio Mattarella has vetoed a proposed finance minister who would, in effect, wreck the euro system. That has led to the collapse of a populist government led by Giuseppe Conte even before it was formed.

Instead Italy is to be run by a former IMF apparatchik Carlo Cottarelli, who will at least calm nerves in Brussels and Frankfurt. President Mattarella is pushing at the limits of the powers of his largely ceremonial role, but is following precedent and acting constitutionally. He is correct to say that the government as a coalition did not win a mandate to depart the euro by stealth.

Fresh elections may follow in the autumn. The chances are they will be no more decisive than the last few rounds. Italy’s drift looks set to continue, yet that may be least worst option facing this stagnant economy.

One of the few things the fractious putative coalition of the League, formerly the near-separatist Northern League, and the Five Star Movement agree on is that Italy should be allowed much more financial freedom, either within the euro or, if needs be, outside it. This is because they need to be able to print huge sums of money on an irresponsible programme, popular or not. The scale of the public spending required to satisfy their populist promises amounts to around 10 per cent of Italian GDP, a figure usually reached only during an extreme economic crisis. They can do that only by a vast increase in borrowing and taking grave risks with the viability of the euro and Italy’s membership of the system.

There is even loose talk about Italy resorting to a second, parallel euro banknote issue, aside from the official European Central Bank notes, via new “mini bots”, mini treasury bonds (the bot standing for buono ordinario del tesoro) with denominations from €10 to €250,000, a boon to criminals and tax dodgers as well as this new breed of Italian politicians. It is a blatant attempt to get round the rules of the single currency.

The likely result would be that either Italy or Germany would leave the system, the latter out of sheer frustration and financial exhaustion. Berlin would be faced not only with higher bills because of Brexit, potentially, but also the cost of bailing out Italy, a far bigger challenge than rescuing Greece a few years ago.

So the stakes are high. The departure of Italy, the third largest economy in the single currency, would be a significant weakening of the system in itself, reducing confidence in its fundamental sustainability. Yet retaining Italy in the system under a regime of fiscal chaos would be hardly more palatable. Either are consequences that the League and Five Star coalition government has no mandate for, hence the presidential veto in Rome of the new finance minister. The one course of action that would reconcile things – a reformed and competitive Italian economy, with correspondingly more stable banks – is the one that it seems no one in Italy wishes to pursue.

As with Greece before, there is a theoretical case for Italy to leave the euro, to ease economic adjustment and facilitate overdue reforms, but it would hardly be cost free. The large national debt would need to be redenominated in some new lira form, with crushingly high interest rates required to attract investors to it, given the likelihood of default. Depreciation and inflation would follow an even more severe Italian debt crisis than the one currently approaching. The euro would face its greatest test yet, and Europe another setback almost as great as Brexit. Italy needs time to think again.