Italians are headed to the polls this Sunday – but no one is quite sure what is on the ballot. On the surface, the voters are considering whether to approve constitutional reforms that should make the government operate more effectively (or not, depending on your point of view). But many people think the real question is whether the current government should stay in power and whether Italy should remain yoked to the Eurozone.

I’ll cut to my conclusion: There is a high degree of probability (approaching 90%,I’d say) that Italy will experience a severe banking crisis in the next few quarters. Perhaps they can stave off the problem for a year, but something will have to be done about the banks. ... since the plight of the banking system is the root cause of all the country’s other problems. Without a banking crisis, Italy would still be the political mess it has been for 65 years,but the banking mess turns the political mess into an economic mess.

There is a significant chance Italy will decide to leave the Eurozone and/or the European Union in the next year or so. Is it likely? No, but we’ve seen less likely things happen recently. Just the discussion of the possibility could be destabilizing to markets that already have enough worries.

If we are lucky, Italy will decide quickly what to do and then do it in a planned, orderly fashion.That would,however,go against everything we know about Italy from experience.

Italian citizens haven’t had much fun the past decade, judging from their GDP. You can see in the left side of the chart below that GDP per person has lagged the EU since 1995. Worse, it kept falling after 2009 even as Italy’s neighbors recovered.

This performance stands in stark contrast to Italy’s pre-euro experience. Even though Italy constantly revalued the lira, that revaluation process allowed Italy to grow its GDP in real terms as fast as Germany did for decades. Notice in the graph above that the real drop off in Italian economic performance began shortly after the introduction of the euro in 1999.

Italy was one of the economic miracles of the ’60s and ’70s. The northern part of Italy was a production powerhouse. The region was strong in the design and manufacturing of all manner of products across a whole host of industries. Even banking was strong. You need to know that Italy is the eighth-largest economy in the world and has issued the third-largest amount of sovereign bonds. This is not a minor country we are talking about. And that mountain of sovereign bonds is really the avalanche-in-waiting that an Italian banking crisis will send tumbling down on the rest of the world, because a large percentage of those bonds are outside of Italy, sitting on the books of banks and central banks.

Note, incidentally, which countries are on top of the pile: Sweden, the Netherlands, Germany,and the UK. The geo-economic split in Europe isn’t imaginary. The northern tier is in better shape than the southern by almost any measure. France and Ireland are the north’s employment laggards,but they are still far better off than Spain, Italy,and Greece.

Italy is problematic for many of the same reasons that Greece, Spain, and Portugal are. Bank customers in these southern-tier Eurozone states borrowed to buy goods from the wealthier north, mainly from Germany;and then the economic growth they anticipated failed to occur.The purchased goods have mostly been consumed,so there is no collateral to recover. Many loans look like near-total losses.

To adapt an old saying: If you owe the bank a million dollars, the bank owns you. If you owe the bank $100 million, you own the bank. Writing off a massive loan as a loss will render the bank insolvent, so instead it goes into “extend and pretend” mode, allowing endless payment delays on the flimsiest premises, hoping against hope that you will win the lottery and resume paying your loan.That’s what is happening in Italy and indeed throughout Europe. It happened in the US during our housing crisis.

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