Italian Prime Minister Silvio Berlusconi offered to resign on Tuesday, and world markets rallied. Stocks, commodities and the embattled euro all enjoyed healthy gains. With that rascally charlatan out of the way, Italy could get finally serious about its economic reforms and the rest of Europe could get serious about resolving its epic sovereign debt crisis.

Or maybe not. The very next day saw one of the biggest selloffs of 2011 due in part to fears that Berlusconi’s absence would only add to political uncertainty and create a power vacuum. The spark that prompted the crash was news that European clearinghouses were raising margin requirements on Italian bonds. Italian 10-year bond yields rose  to over 7% — the level at which Greece, Ireland and Portugal had to be bailed out — leaving investors to ponder existential questions about the euro itself.

Not only was Italy too big to fail, it was too big to bail. Stocks, commodities the euro, and even gold — that supposed “crisis hedge” — all saw substantial losses.

And then, Thursday, all was well in the world again. Italy sold new bonds at lower yields than expected, a new Italian prime minister was waiting in the wings and stocks, commodities and the euro rallied. Friday brought even more relief to equity markets as Italy moved to adopt an austerity budget, and the Dow gained nearly 260 points, and actually ended up 1.4% for the week.

If this brief history makes no sense to you, don’t feel bad. That just means you’re thinking logically. And there’s nothing logical these days about the currency and sovereign debt markets.

Italy’s debt burden is well known. It currently stands at 120% of GDP. No wonder the country is viewed as a threat to European financial stability.

Yet Italy is actually one of the strongest economies in Europe. Yes, that’s right. The Italian banking system avoided most of the turmoil of recent years, and Italy runs a primary budget surplus. (This means Italy’s budget is in surplus before interest payments on existing debt.)

Let’s compare this to a supposed safe-haven country — Japan.

Japan’s debts are well in excess of 200% of GDP — by far the highest in the G20 — and the country is adding to that debt at an alarming rate. Japan’s budget deficit is projected to be 10% of GDP this year. Yet Japan has actually had to intervene recently to force the price of the yen down. Traders can’t seem to get their hands on enough yen, and the Japanese 10-year bond yields a shockingly low 1%.

This is no defense of Italy, of course. Frankly, if the bond market vigilantes are doing their jobs, Italian bonds should trade at substantial premiums to those of their Northern European neighbors. But where were these vigilantes over the past decade? And why aren’t they now punishing Japan?

Don’t ask why, dear reader. It’s like trying to understand the fashion trends of teenagers. There is no answer.

The Italian crisis is a bit of a self-fulfilling prophecy. After watching Greece implode, bond traders fear that Italy will be next. So they sell Italian bonds in anticipation, which causes yields to rise and makes it difficult for Italy to pay its bills — thus creating the very crisis they feared.

So, with all of this as a very long introduction, let’s see what Nouriel “Dr. Doom” Roubini  has to say about Europe and the euro. In a new paper, “Four Options to Address the Eurozone’s Stock and Flow Imbalances: The Rising Risk of a Disorderly Break-Up”, the often-prescient Roubini offers four sets of policy options:

1. Growth and competitiveness are restored through aggressive monetary easing, a weaker euro and fiscal easing in the core (i.e. Germany), while the periphery states (Greece, Italy, Spain, etc.) undergo fiscal austerity and structural reforms. The euro survives, with perhaps a few defections from the single-currency zone.
2. A deflationary/depressionary adjustment that pushes down wages and prices to regain competitiveness. Growth is depressed for many years. This is what Germany advocates and what we are seeing today.
3. The core permanently subsidizes the periphery– via both debt reduction and bailouts.
4. The eurozone sees widespread debt restructurings and eventually breaks up to restore competitiveness.

These four options can lead to three possible outcomes. The first — to which normally bearish Roubini assigns a surprisingly high 40% likelihood — is that everything in policy option one goes as planned, Italy and Spain return to growth and all is well in the world.

Roubini assigns a 50% probability that not much of anything gets done, we muddle along in a fragile status quo for another year and a muddled mix of policy options 2 and 3 become the de facto non-decision decision. Roubini puts the odds of widespread default and euro zone disintegration at 10%.

Click to EnlargeOne point should be immediately clear. None of these options bodes well for the price of the euro, which remains surprisingly expensive at present (see chart). Monetary easing by the European Central Bank — including, but not limited to, lowering the benchmark rate and aggressively buying Italian and Spanish bonds — should cause the euro to fall against the dollar and other major currencies. In fact, the euro’s surprising strength vis-à-vis the dollar is largely due to the ECB’s hawkishness relative to the U.S. Fed.

Because options 2 and 3 carry significant political risk and virtually guarantee that this crisis will linger for years into the future, these two scenarios should also be bearish for the euro. And clearly, option 4, in which the euro zone may cease to exist in anything resembling its current form, would be catastrophic to the value of the common currency.

John Maynard Keynes famously said that the market can remain irrational longer than you can remain solvent, and nowhere does this hold truer than in the world of currency trading. Still, investors willing to brave the currency minefield should consider the euro as a possible short.

As the chart makes abundantly clear, the euro can defy its critics for months at a time, particularly given how unappealing its primary competitors — the dollar and yen — are. But the overall direction over the next several years should be down.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. Sign up for a FREE copy of his new Special Report: “3 Safe Emerging Market Stocks for a Shaky Market.”