The European Central Bank may be forced to sever credit lines to Italy in a drastic financial showdown if the country's insurgent coalition tears up EU spending rules and subverts the treaty foundations of the euro.

Prof Clemens Fuest, head of Germany's influential IFO Institute, said the EU authorities cannot stand idly by if the neo-anarchist Five Star Movement and anti-EU Lega nationalists press ahead with revolutionary policies and endanger the stability of monetary union.

Prof Fuest warned that the ECB would have to sever Target2 credits to the Bank of Italy within the internal payments system, potentially bringing the crisis to a climactic head.

"If they start to violate eurozone fiscal rules, the ECB will reluctantly have to act. It will be like the Greek crisis. Italy will have to introduce capital controls and will be forced out of the euro," he said.

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"It would be a massive blow but I think the euro would survive with France and Germany, and Spain, still in there. It would be a different euro," Prof Fuest continued.

The German establishment has reacted with fury to a leaked plan by the Lega and the Five Star "Grillini" to overthrow the disciplinary architecture of the euro project, warning that it kills off any chance of German assent to shared debts or tentative fiscal union.

"The bottom line is that they are issuing almost an ultimatum. They are saying that either there are fundamental changes to the eurozone, with fiscal transfers for Italy, or they will leave the euro," Prof Fuest told the Daily Telegraph.

He said the original draft text prepared by the two radical parties exposed their ideological reflexes and fatally damaged trust, even if the final text is being toned down.

"It has confirmed people's worst fears and had a very bad impact in Germany. How can you have a shared deposit insurance [for banks] with a government like that in Italy? It is just unthinkable," he said.

"They are threatening to undermine the Fiscal Compact and the Stability Pact and the entire institutional basis of monetary union."

German economists have been stunned by radical demands for a cancellation of £185 billion ($363) of Italian bonds held by the ECB. The clause has since been removed but the damage is done.

"Italy's policy is unmasked. They want others to finance their debt," said Lars Feld, one of Germany's "five wise men" on the Council of Economic Experts.

"Why should there be any risk sharing in EMU if the new Italian government asks for a €250bn haircut? It is time to ring-fence against Italian risk," he tweeted.

Hans-Werner Sinn: There is no possible solution to this. The catastrophe is happening. This is going to lead to the destruction of Europe, to say it bluntly.

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Whether the fall-out from "Italexit" really could be contained is an open question. Many think contagion would spin out of control.

Furthermore, it is the intention of some Lega-Grillini hardliners to force Germany to leave the euro by making it unworkable.

Italy's Target2 debt within the ECB's internal payments nexus has become a neuralgic subject. The liabilities topped €426b in April - 26 per cent of GDP - reflecting chronic capital outflows from the country. The worry is that they might spike to systemic levels in a crisis.

Willem Buiter, Citigroup's chief economist and a former UK rate-setter, says weaker EMU central banks are little more than currency boards. They can go bankrupt and are not "credible counterparties".

He argues that the ECB may ultimately have to suspend funding lines to "irreparably insolvent" central banks in order to protect itself.

The policies of the Five Star Movement, lead by Luigi Di Maioand, and anti-EU Lega nationalists may endanger the stability of European monetary union. Picture / AP
The policies of the Five Star Movement, lead by Luigi Di Maioand, and anti-EU Lega nationalists may endanger the stability of European monetary union. Picture / AP

Hans-Werner Sinn, economist at Munich University, said there is no mechanism for Germany to retrieve the vast sums that it has sunk into the eurozone, including the €923b ($1.6b) of Target2 credits owed to the Bundesbank.

"We will never get the money back," he said.

Prof Sinn said the structure is equally unworkable for Europe's north and south, leaving both in a state of smouldering resentment.

"There is no possible solution to this. The catastrophe is happening. This is going to lead to the destruction of Europe, to say it bluntly. It will also bring AfD (Right-wing populists) to power in Germany," he said.

The Lega and Grillini were still arguing over the terms of their deal yesterday.

There is no agreement on the choice of Prime Minister. Five Star intends to submit the coalition plan to an online vote. Italy's constitution gives President Sergio Mattarella de facto power to impose the Premier and the Finance Minister. He can order the government to stay within agreed EU treaties.

But these are largely untested waters in the Italian post-war republic. If he pushes too hard, talks will collapse and lead to a fresh election. Polls suggest the insurgent parties would increase their votes.

The developments doom Emmanuel Macron's hopes of a "grand bargain" for the eurozone. The French leader had been gambling Germany may accept steps towards economic union, with a eurozone budget and finance minister, if France delivered on economic reform.