The situation in Italy is now beyond the point of repair. With debt yields above 7%, it’s a matter of time before Italy cannot afford borrwing. And there’s only one mechanism with the ability in Europe to bail them out. That’s the European Central Bank, and they have been enabling the crisis more than anything:

Far from struggling to manage a “one size fits all” monetary policy, the bank has pursued a “one size fits nobody” policy of monetary contraction, at a time when no European economy is growing strongly. With great reluctance, the bank has agreed to support the markets for European sovereign debt through purchases of government bonds. But, unlike the policy of quantitative easing pursued by the Federal Reserve — in which the United States’ central bank amassed Treasury securities to push down long-term interest rates — the European Central Bank has insisted on “sterilizing,” or neutralizing, its purchases of government bonds by selling the securities to private-sector banks. Such a policy cannot be sustained on a scale sufficient to stabilize financial markets [...]

Unlike any previous central bank in history, the bank has disclaimed any responsibility for the European financial system it effectively controls, or even for the viability of the euro as a currency. Instead, it has focused almost entirely on the formal objective of keeping inflation rates to a 2 percent target [...] If current policies are pursued, the European Central Bank will end up by destroying the euro in order to save it from (largely hypothetical) inflation.

The new ECB head, Mario Draghi, did cut interest rates, reversing one disastrous policy. But the bazooka needed now due to the collapse of Italy – thanks in part to its incompetent leadership – is not something the ECB has shown any willingness to use. Heck, they won’t even buy Italian debt without hedging it off.

And now we have Angela Merkel and Nicolas Sarkozy discussing the previously unthinkable – what amounts to a breakup of the euro.

German and French officials have discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller euro zone, EU sources say.

“France and Germany have had intense consultations on this issue over the last months, at all levels,” a senior EU official in Brussels told Reuters, speaking on condition of anonymity because of the sensitivity of the discussions.

“We need to move very cautiously, but the truth is that we need to establish exactly the list of those who don’t want to be part of the club and those who simply cannot be part,” the official said.

These are apparently “toe-in-the-water” discussions, and you’ll never see the idea articulated in public until it happens. But essentially, it would have France and Germany creating an inner ring around the euro, and making determinations about who can stay and who can go. The inner ring would have a tighter fiscal core, and the other countries would be set adrift.

So far, Merkel is only talking about “more Europe, not less Europe” in public. But this exclusive from Reuters is a key tell. The euro is done for. And while that’s probably the right move, to kill the virus before it lingers, it will take so long to unravel this wrongheaded system that a lost decade in Europe, if not the rest of the globe, is increasingly likely.

UPDATE: DeLong: “The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.” It’s firewall time.