When will the slow-burning crisis in Italy ignite?

When the financial crisis erupted in 2008, the response from politicians and central bankers was to smother the whole thing with a big blanket of printed money.

That was meant to deal with the initial conflagration. We'd then have time to sort things out so that it wouldn't happen again.

We haven't done as much restructuring as many of us would like. The "too big to fail" issue in particular hasn't been resolved.

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But many banks are healthier. And we can probably argue that the next crisis won't look the same as the last one as a result.

There's just one area where I'm not as convinced that this is true.

And that's the eurozone.

Italy is not a hard-currency country

Italy has a very heavily indebted economy, even by today's standards. The national debt is sitting at more than 130% of GDP.

Italy also has a very weak economy. It has stagnated pretty much since it joined the eurozone.

You can blame this stagnation on lots of things unhelpful business regulations; overly generous public-sector wage and pension settlements; the fact that Italy is really two countries (a productive urban north and a struggling rural south, to put it very simplistically) bolted together.

But it's not a coincidence that Italy's long period of economic stagnation overlaps so neatly with its joining the euro.

Whatever the exact reasons, Italian society is structured in such a way that having a "hard" currency doesn't suit it. Historically, Italy has needed and made use of the pressure valve of being able to devalue its currency, in order to make clearing its debts less painful.

You may argue that Italy should get a better grip on its political and economic governance. You might argue that one reason for having a hard currency is that it might force you to get a grip. I might even agree with you.

However, that's for Italian voters to decide. It's not really up to me. And technically speaking, it's not really up to the European Central Bank (ECB) or any other pan-European body to make those decisions either.

Yet in reality, it is. And that rather sums up the tricky pass we've come to in the eurozone.

The euro is a political project, and voters still want to hang on to it

You see, the Italian government has just pushed through a budget. The team at the top is now targeting a budget deficit (ie, an annual overspend) of 2.4% of GDP for each of the next three years.

The Italian government is a coalition of the Five Star Movement (described as anti-establishment, because they hold a mishmash of left and right wing views), and the League (who are far right, as in anti-immigrant).

The problem is that the previous Italian government told the European Union that it would try to bring the annual overspend down to just 0.8% next year, and then run a surplus (ie, start paying off its massive national debt) in the two years after that.

So deciding that, instead, they're going to triple that deficit and then keep running it for the foreseeable future is quite the change of plan. Indeed, it's the equivalent of sticking two fingers up at the rest of Europe.

Markets reacted accordingly. The yield on Italy's ten-year bonds rose (in other words, it became more expensive for Italy to borrow money over ten years, because markets downgraded its creditworthiness for the time being).

The question is, what happens next? Oliver Jones of Capital Economics points out that there are a few reasons why for now investors need not fear that we are heading for a tedious repeat of the Greek "will they, won't they?" crisis.

While Italy's bond yields rose, the other peripheral countries were largely relaxed so we're not seeing "contagion".

Investors understand that, like Greece, Italy wants to have its cannoli and eat it. The government wants to hike public spending and it might also be a little mouthy about the EU in the process. But for now at least, Italians also still want to hang on to the euro.

Somewhat ironically, that's because the euro is a hard currency, or at least it is compared to the alternative, which would be the new lire, or something similar.

You see, people might not like the effects that a hard currency can have on their economy. But ask them if they're willing to swap the savings they hold in a hard currency for a soft one instead, and they'll change their tune pretty rapidly.

The euro as Greece taught us, if we didn't already know is a political project. If it's going to collapse, it'll be because of politics. So until a eurozone country explicitly votes to leave the euro, it's seen as being unlikely to collapse.

But there's a but here...

However, that does assume the support of the other nations in the EU. Which is still, to a very great extent, underwritten by the willingness of the ECB to do "whatever it takes".

As Jack Allen of Capital Economics notes, Italy isn't going to magically get better. You can certainly argue that more public spending might help growth more than austerity, but not if the money is essentially wasted. As Allen notes: "The economy is uncompetitive and the banks remain weak, which will weigh on productivity growth. Meanwhile, the demographic outlook is poor As a result, we expect Italy's debt ratio to keep rising."

In other words, Italy appears to have no chance of growing its way out from under its huge debt pile without the sort of radical reform that has no chance of happening under any recognisably Italian government.

So all of this still leaves the small matter of Italy's actual debt. For now, the existence of a price-insensitive, politically-motivated buyer the ECB prevents yields from blowing up.

Yet already Italian debt is trading as though it were less highly rated by the credit rating agencies than it currently is. And as Eoin Treacy of FullerTreacyMoney points out, "large pension funds which have been gobbling up Italian debt to capture the higher yield would be forced to sell in the event of a downgrade".

So what happens when the ECB drops quantitative easing altogether? Worse still, what happens when Mario Draghi stops being head of the ECB (his term is up next year)?

I suspect that a surprising amount of the calm that has blanketed the eurozone in recent years is entirely down to faith in Draghi, who is, in many ways, the ultimate central banker. Once he steps away from the controls of the economy, the risk is that his successor will not be able to inspire the same faith in markets.

It's just a question of when that loss of faith starts to be priced in. That depends partly on the tone coming out of Italy. But I don't think we'll have to wait until the day Draghi steps down to start seeing the consequences.