So why is everyone so concerned about the Italian election? Well the sort of money required for an unlimited bond buying programme of a large country such as Italy or Spain would put immense strain on the relationship between ECB and the Bundesbank (Germany’s central bank) – if a country’s politicians were not prepared to agree to an EU-sanctioned austerity programme, this would greatly exacerbate this strain.

The Italian people have spoken and we are pleased to say that the major fear in markets – a Silvio Berlusconi victory (with a radical protest agenda) – was thankfully avoided, although he and ex-comedian Beppe Grillo did receive about a quarter of the vote. The actual outcome was only slightly more desirable – a hung parliament and uncertainty in Italy.

Pier Luigi Bersani’s centre-left coalition won by a very small majority in the lower house but failed to win a majority in the upper house. Technocrat Prime Minister Mario Monti, who resigned in December, was the only politician promising to continue Italy’s economic reforms – he received a mere 10% of the vote. Bersani’s support for such measures was lukewarm, while Berlusconi and Grillo actively campaigned against them.

Given Bersani needs a majority in both houses to govern, he will be trying hard over the coming weeks to form a coalition in the senate. If not it will be back to the polls.

In order to qualify for support from its European neighbours, Italy has to continue its current reforms and spending cuts, but the Italian citizens have all but rejected them. This presents a problem for Europe’s politicians and central bankers. They cannot bail out Italy if they will not agree to do anything in return, but they cannot afford to let Italy fail as its size would have a significant detrimental impact on both Europe and the world.

Italy’s problems are predominately debt related and less budget deficit related. Excluding interest payments for existing debt, Italy would be running an annual budget surplus. However they do have interest payments, so the reality is they are running a deficit of 2.7% of GDP and their public debt sits around 130% of GDP – and whilst Italy continues to run deficits this will grow every year.

How did this happen? Italy’s economy is heavily regulated and uncompetitive which has meant they have had virtually no growth for 14 years. Continued reforms are necessary to get out of this mess. It is worth noting that the International Monetary Fund (IMF) estimates that labour and product market deregulation alone could raise its GDP by over 10% over ten years.

Ultimately there is a lot of work ahead and many European countries face a prolonged period of below average economic growth due to the effects of both fiscal austerity by Governments and the deleveraging of banks and households.