The market has figured out that the worst-case option – an electoral alliance between the welfare-subsidy populists of the Five Star Movement and the tax-cutting populists of the Northern League – is the most likely for Italy’s new elections, which may take place as early as July.

A simulation by the Cattaneo Institute, a respected Italian polling organization, shows that the League-Five Star combination would gain a strong majority in both houses of the Italian parliament. As Asia Unhedged has noted, that would set Italy on a course to leave the eurozone.

Correspondingly, US bond yields are plummeting as investors dive for safety. On Tuesday afternoon, the US 10-year note yield was trading a full 35 basis points below the intraday high on May 18. The Dow-Jones Industrial Average was down by as much as 1.75% and the S&P 500 was down by as much as 1.57%.

We repeat: This is not a drill.

Some commentators think Italy’s populist parties want to blackmail the European Community – that is, the German taxpayer – into bearing a great deal of Italy’s debt bill, either through canceling Italian debt held by the European Central Bank, or by paying for a bank guarantee scheme that would mainly be funded by Germans and mainly used by Italians, or by financing Italy’s budget through the European bonds collective guaranteed by the members of the EC (that is, the Germans).

Other commentators think that Italy’s League party plans to withdraw Italy from the eurozone and substitute a devalued national currency for the euro. They’re both right. The League floated a plan to pay off creditors of the Italian state in government scrip (called mini-BOT’s), which in turn could be used to pay taxes, or buy gasoline at government-owned stations, or anything else the government sells.

In effect, the government would create a parallel currency which would be tradeable, and would instantly trade at a discount to the euro. According to government officials in other European capitals with close relations to the League, the northern Italian populist party has been “underestimated” by the market. The League wants to squeeze the Germans for everything they can get while creating an alternative currency at the same time.

The endgame for Italy’s US$2.3 trillion of government debt (now equal to 130% of GDP) is debasement of the currency – the government will pay its obligations in a cheaper currency.

In the meantime, the Italians will try to collect as much as they can from their European Community partners. The result will be the end of the euro, or its reduction to a rump consisting of a few northern European countries. The EC will revert to its origins as a modest customs union with no common social, fiscal, or monetary policy.

The long-suffering German taxpayers will only play along with Italian blackmail for so long. Yesterday, for example, Die Welt, the leading right-of-center broadsheet, arguing that if Italy collapses, Europe will have no choice to bail it out. The piece attracted 700 comments, every one of which argued that kicking Italy out of the eurozone was a better idea.