This is not a drill. This is the real thing. The giant popping sound you hear is Italian government debt evaporating. The yield on Italian government two-year notes has risen by nearly 3 full percentage points this month, from around -0.35% at the beginning of May to about 2.5% this morning, in response to a populist rebellion by Italian voters.

For Italy, that portends disaster: with government debt at 130% of Gross Domestic Product, the additional interest cost at higher yields amounts to 4% of GDP.

Italy’s populist parties, the Liga and Five-Star Movement, are proposing tax cuts and welfare payments equal to more than 5% of GDP. But their demands have triggered a crisis of confidence in Italy’s $2.3 trillion debt load, the third-largest in the world.

Instead of a new era of populist state largess, Italy faces massive reductions in government spending to compensate for higher borrowing costs. But the voters have revolted against the Italian Establishment that nursed the eurozone’s third-largest economy through the financial crisis of 2013, and no political will exists to manage the present crisis.

That is why the Italian debt markets have careened out of control, and investors are buying American and German bonds. The 10-year US and German bond yields have fallen by a third of percentage point in the past week as investors seek a safe harbor.

Yield on Italian government 2-year notes

Italy’s voters gave a near-majority to the two populist parties, who represent different constituencies with different interests. The Liga is a northern business party that wants lower taxes, while the Five-Star movement appeals mainly to southern Italian voters who want more welfare payments and higher pensions. These are diametrically opposite demands: the main complaint of the northern voters is that they pay taxes to subsidize the impoverished and corrupt south.

Nonetheless, the populists allied on a program that includes both their demands, with spending requirements that would bust the Italian budget. They failed to form a government under Italy’s arcane political system, so the country will hold new elections in the fall, with months of uncertainty ahead.

Italy’s debt is so large that the country can’t grow its way out of it. Italy has had virtually no economic growth since the 2008 financial crisis.

The usual way of reducing government debt of this magnitude is to inflate, and reduce the real value of debt. That typically involves a currency devaluation. As long as Italy remains in the Eurozone, however, it does not have the option of devaluing. The Liga has proposed to pay government bills in scrip, that is, to issue a parallel currency which can trade at a discount to the Euro – a devaluation by stealth. European officials see that as a step towards abandonment of the common currency.

Between the 2013 financial crisis and the beginning of 2017, the European Central Bank expanded its balance sheet holdings of European bonds from about $2 trillion to about $4.5 trillion. In effect, the European Central Bank’s quantitative easing financed virtually the whole of Italy’s government deficit.

The European Central Bank simply can’t do this again. Europe doesn’t have the means to bail out Italy a second time. The danger is that some Italian debt will be re-issued in a devalued local currency (some Italian government bonds protect investors against redenomination into another currency). A shock of $2.3 trillion to European government debt would be painful for the European banking system.

The arithmetic doesn’t add up for another Italian bailout, and that explains why government markets have reacted so violently. The whole project of European unification may have foundered this week; the European Community may devolve into a mere customs union.

Italian debt does not represent the sort of risk that mortgage derivatives posed to the financial system in 2008, to be sure: foreign holdings of Italian debt fell from about $900 million in 2010 to $700 million this year. Most Italian debt is held by Italian entities, especially Italian banks, who hold more than 20% of the total. The direct impact of an Italian debt crisis is likely to be localized in Italy, and absorbed by the issuance of a new, devalued Italian currency.

Italians will be much poorer, but the world financial system will survive.