Can a new prime minister save Italy?

After two months of political deadlock, Italy has formed a new government. The first grand coalition since 1946 will contain ministers from both the centre-right and centre-left blocs, plus a few technocrats. Investors' initial reaction was positive.

Italian stocks rose and ten-year bonds yields fell to 3.9%, their lowest level since October 2010. In late 2011, they exceeded 7%. But this does "not necessarily look like a recipe for smooth government", says Mike Peacock on Reuters.com. The parties are hardly naturally compatible and the "leftward part of the centre-left" in particular could find it "too hard to stomach".

Markets are watching Italy especially closely, thanks to new prime minister Enrico Letta's recent calls for Europe and Italy to ease up on austerity and go for growth. "We will die of fiscal consolidation alone", he said this week. Already he has decided not to impose the first instalment of a property tax planned by his predecessor, which will leave a €6bn hole in the budget he has yet to account for. Nonetheless, investors hoping for a major break with the past may be disappointed.

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According to Ambrose Evans-Pritchard in The Daily Telegraph, "it is hard to imagine a man less inclined to throw down the gauntlet and force a radical change in EU policy before Italy's economy chokes to death". Letta wrote his PhD on EU Community law. He appears to be a classic EU insider "just as wedded to the EU project" as his predecessor, whose austerity and reform programme was rejected at the polls in February.

In any case, says the FT, "Germany has a jaundiced view of Italians keen to ease up on austerity when their structural reforms are at best half-complete [and] tax evasion remains rife".

The budget deficit target is already slipping, so there seems to be little scope for the EU to be much more generous to Italy, says Capital Economics. The target for this year has been revised from 1.8% of GDP to 2.9%. There is a danger that the economy will shrink faster than expected and push the shortfall to 4% of GDP this year. The overall debt pile could grow to 135% of GDP.

And with many fearing that the government won't last long, the scope for more structural reform to boost Italy's long-term growth and cut its debt looks limited. Market fears of an eventual bail-out may soon return.