Italy: 'Hang on lads, I've got a great idea…'

Hedge funds are short-selling Italian banks for a reason. They fear the banks may not pass the revamped EU stress tests.

That, plus the open row between Silvio Berlusconi and Giulio Tremonti, his finance minister - oh, and big demonstrations against austerity - have opened up Italy as a new front in the battle to save the Euro. Or destroy it, depending on who you are.

This is bad news first of all for Spain: Spain's debt had begun to trade in parallel to Italy's - meaning, rationally or otherwise, investors had begun to see the two countries as anchored in the saveable part of South Europe's economy.

Now, with Greece acting like a Black Dwarf, pulling the other troubled countries towards the orbit marked bailout, bond investors are starting to contemplate a total disaster scenario.

Italy has to pay 3% more than Germany for its debts in the same currency; Spain is dragged back above 6 percentage points.

Why is Italy important? First of all, its banking system had not quite been caught up in the free-market craziness that preceded the crash, so the "fundamentals" were OK in its financial system.

Its government finances are a different question. It has a high debt - 110% of GDP - but this was manageable because those who lend to the Italian state are, largely, the Italian people.

Its bond market is massive, liquid and largely internally financed. At Euro 1.15tn, it is third biggest in the world, smaller only than the US and Japan.

What's happening is a "reflection effect" from Greece. What we are seeing is "what happens post a Greek default" played out on the screens of bond traders: your first impulse is to reduce exposure to anything that looks like Greece.

And with widespread derision for Berlusconi on the trading floors of London, Paris and New York, Italy looks like Greece, six months down the line, but with no photogenic riot dog.

Where does it go? One highly apocalyptic analyst, speaking highly off record, believes that if Italy gets dragged into the high-interest rate world, its banks will find this unsustainable.

As per Liam Halligan in the Sunday Telegraph: there is no such thing as a "risk-free rate" set by sovereigns anymore, and you get an unsustainable hike in the bank borrowing rate in Italy which sinks the aforementioned Italian banks and then the contagion spreads to France.

The stable part of the Euro is really then Germany, Austria, Finland and the Netherlands - four "core" solvent countries.

What's the solution? You will read numerous articles saying: either let Greece default (and some others) to save the Euro; or issue Euro bonds, backed by the tax take of all 17 countries, and start transferring taxpayers' money from north to south. It's always posed as a stark alternative, as if there were a single European brain, or polity, that could take this decision.

Facts on the ground are superseding this: to save Greece, you would have to do Euro bonds, and a Marshall Plan, take losses on the debt, and - maybe - even allow some degree of temporary autarky to overcome the social crisis. These are all ideas floating around off the side of the desks of bond holders and Euro-thinkers.

We are not in that moment yet, but as one market participant pointed out: today's 60bp rise in the yield of Italian bonds is a "big move in a massive market".

Another way of saving Greece, Italy and everybody else would be for the ECB to permanently extend liquidity on a vast scale (as it does for Greece), swapping its good money for their bad money on an open-ended basis. All this does is hasten the day when someone asks where the ECB's money comes from, which is of course the taxpayers of France, Germany, Netherlands, Austria and Finland - if the recipients are going to include Italy and Spain.

Whether we hit the barriers of political unacceptability or a market attempt to take down the ECB first is a question everybody hopes we never have to answer, but markets have staged attacks on central banks before.

The grit in the oyster, constantly, in those observing Italy's slide into the crisis zone, is the persistent low growth and high trade deficit in Berlusconiland. The fundamentals are going in the wrong direction.

But on a day when markets - not distracted by Rupert Murdoch - have been focused laser-like on the Italian crisis, I'm reminded by Michael Caine's immortal last line in The Italian Job: "Hang on lads, I've got a great idea."

It's time somebody had one.