SILVIO BERLUSCONI'S promise to resign has done nothing to calm European bond markets. Italian bond yields are soaring today; both the two-year and the ten-year are above 7%. There are rumours that the ECB is in the market and buying heavily. If so, it's not having the desired effect. The ECB can't hope to keep yields reasonable through brute force. It will need to make an expectations-changing announcement. Will it? Italy's yields aren't the only ones rising. Markets are ditching Irish, Spanish, Belgian, and French debt too. The ten-year Treasury is back below 2%.

Yesterday, I wondered why equities weren't falling. Today, they are. But I think Tim Duy is on to something here:

All I can say is that we have been here before. Recall 2007... By the middle of 2007 the TED spread was exploding, signaling enormous financial turmoil. Yet equities kept heading upward, fueled by data that was just not that bad coupled with ongoing expectations that a solution was just around the corner. And now we find ourselves in almost the exact same position...the news out of Europe is abysmal...There is no solution, no magic summit at hand. At this point, it is a choice between severe recession and depression. There is no happy ending to this story.

I have been examining and re-examining the situation, trying to find the potential happy ending. It isn't there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world's eighth largest economy and third largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn't clear, but it's unlikely to be pretty.

Can this cycle be interrupted? I think so. I think that an ECB guarantee to backstop sovereign debt, coupled with massive purchases to establish credibility and a substantial easing in monetary policy, could change the dynamic, particularly if quickly followed up with a major fiscal commitment from core economies to support bail-out efforts and invest in peripheral economies while peripheral economies focus on substantial labour market, public-sector, and tax reforms. How likely does all of that sound? Could the ECB even commit to the above bold actions without facing debilitating criticism, and perhaps intervention, from national governments?

I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can't believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur. And I still don't understand why, if this is all as obvious as it seems to me, equities aren't down 20% now, rather than 2% or 3%. But the window within which something could be done to prevent it is closing, and fast. I hope to be proven astoundingly wrong in my assessment, but I'm struggling to see alternative outcomes.