Mr Bini-Smaghi told Avvenire that the budget deficit for 2019 will be 3.5 per cent of GDP, far higher than the 2.4 per cent estimate that Brussels immediately rejected as too high.
"This is going to unleash mass selling by investors, and risks a snowball effect," he said.
The Italian banks hold €380 billion ($611 billion) of the country's -sovereign bonds. Insurer Generali alone holds another €60 billion. The rising spreads will cause mark-to-market losses and erode the capital buffers of the banks, forcing them to rein in credit. "The whole banking system, whether big institutions or small, risks running out of funds for the real economy," he said.
Brussels has been treating the budget showdown as a problem for the Italians - much as it treats Brexit as a UK problem - but the dispute is inherently double-edged. Ultimately it threatens a systemic pan-EMU crisis and the survival of the euro itself.
"The clock is ticking for Europe," said Claudio Borghi, the Lega economics chief and budget chairman in the Italian parliament. "We're going into a world economic downturn and that is a disaster for the eurozone." He said a protracted crisis works to the advantage of the insurgent Lega-Five Star government.
"We already saw contagion to Spain, Portugal, and even France when the spreads got to 340 last week," he said.
Italy is on the cusp of recession. Credit: AP
"It hurts of course if stock markets are falling everywhere, but it helps us politically.
"The truth is that Europe cannot survive without the cushion of QE. The ECB is going to have to relaunch QE next year and as soon as that becomes clear, you'll see the spreads come back down to 50 overnight. These spreads have nothing to do with our mildly expansionary budget. They are a function of whether or not there is a central bank guarantee.
"Brussels would love to see our defeat. They think that we'll surrender if they cause a crisis for our banks. But we still have €15 billion left in the bank rescue fund from the Renzi era. It is not a great situation but we're still relatively comfortable. In the end, it will be they who have to back down. The only thing we will change in our budget letter is the font."
Mr Borghi dismissed a German plan over the weekend for the mass seizure of Italian private savings as ivory tower madness, warning that any such move would detonate a systemic banking crisis and the rapid disintegration of the euro.
Karsten Wendorff, the Bundesbank's veteran finance chief, proposed "national solidarity bonds" to cover half of Italy's €2.3 trillion debt. This would be funded by a mandatory wealth tax of 20 per cent on the net private assets of the Italian people.
It would supposedly head off the need for help from the eurozone bail-out fund (ESM) or from the ECB, and therefore spare north European taxpayers any consequences from the eurozone's chronic structural crisis.
Mr Borghi said Italian private wealth is not held in liquid assets. Attempts to collect such vast sums would set off a cascading fire-sale of bonds, equities, and property, causing a rapid collapse of both the Italian and EMU financial edifice. "It would crush the banking system. This would not even work in theory."
Long before it reached that point, the Lega-Five Star government would have to take emergency measures to defend Italy through temporary control of the banks and activation of their "minibot" plan for a parallel liquidity. This would set in motion a de facto breakdown of monetary union.
Italy's woes threaten to spread throughout the EU. Credit: Bloomberg
Giovanni Tria, the finance minister, said Rome would act fast to shore up lenders if compelled by events. "The banks are still solid. For the time being there are no dangers. If there is systemic stress, clearly the state must intervene," he said,
While Mr Wendorff presented his plan in the Frankfurter Allgemeine as a private opinion, it follows a drumbeat from the Bundesbank and the German Council of Economic Experts for debt-restructuring before there can be any rescue of Italy or other eurozone states. They have brushed aside warnings from ECB's former president, Jean-Claude Trichet, that such plans would risk a "catastrophe". It would repeat the Deauville "walk on the beach" decision by the French and German leaders to haircut Greek debt against the advice of Frankfurt. It set off EMU-wide contagion.
Lorenzo Codogno, former chief economist of the Italian treasury and now at LC Macro Advisers, said the eurozone's northern bloc would demand "debt re-profiling" on Italian debt as a condition for any ESM bail-out - should the rebel government ever agree to request one, which is doubtful.
This would probably be a 20 per cent default, chiefly by stretching the maturities on the debt rather than as a haircut. It would still trigger bankruptcy insurance on Italian credit default swaps. He said international investors do not seem fully aware that this may be coming, or how risky this precedent could be for other Club Med debtors.
Mr Codogno said Italy is already in crisis and that the credit data for September and October will reveal the extent of the credit crunch. Capital flight is already in full swing.
Europe faces a quandary. Survey data shows that Italians fell out of love with the euro long ago, but fear the trauma and losses of leaving monetary union would be unbearable.
The more that the EU authorities talk of debt-restructuring or forced wealth taxes as the exorbitant price for staying in the euro, the greater the appeal of the lira for large blocks of the Italian nation.