By Gavin Jones
ROME (Reuters) - Italy's election produced the hung parliament investors said was the worst possible outcome, recession is deepening, debt is rising and its credit rating has just been downgraded.
So why do markets seem largely unconcerned?
Italy's benchmark borrowing costs have edged up to around 4.6 percent from 4.5 before the election and the gap between safer German Bunds has risen to 3.1 percentage points from around 2.9 points.
That is a negligible reaction to economic sickness and political gridlock in the euro zone's third largest economy. The crippling bond yields above 7 percent at the height of the euro zone debt crisis in November 2011 remain a distant memory.
"I'm surprised and it may be complacent," said Gilles Moec, European economic research head at Deutsche Bank.
Other economists were equally puzzled, and wonder whether this is just the calm before a market storm. The trigger could be another ratings downgrade, a failed attempt to form a government or even bad economic data from the United States.
However, there are logical explanations for markets' relative indifference.
The first and most important is that the euro zone debt crisis has subsided and Italy is proving a major beneficiary of last summer's pledge by European Central Bank chief Mario Draghi to do "whatever it takes" to save the currency bloc.
Other factors are an improved international growth outlook that is buoying market sentiment generally, and the increased proportion of Italian debt held domestically.
There are doubts about many aspects of the ECB's pledge to buy the bonds of ailing euro zone countries that ask for help -- not least if there is no durable Italian government, or one that is prepared to stick to the austerity track.
But until its backstop, known as Outright Monetary Transactions (OMT), is tested and shown to fail, markets are still viewing it as a game-changer.
"What we are seeing is that the effect of the OMT is truly powerful," said Marco Valli, chief euro zone economist at Unicredit. "A year ago if Italy were in this situation (bond yields) would have been going through the roof."
Markets are no longer betting against the euro and so they are not taking aim at the bloc's weakest members, like Italy.
"This was the only region in the world where countries could default at any time because they didn't have a central bank behind them," said Mizuho chief economist Riccardo Barbieri. "With OMT we now have something that approximates to having a central bank."
Another consequence of the euro zone crisis is that more Italian debt is now in domestic hands after its banks stepped up to the plate to replace fleeing foreign investors. That makes the debt less vulnerable to changes in international sentiment towards Italy and supports bond prices.
Foreign holdings of Italian debt fell last year to a trough of 35 percent from 51 percent in mid-2010.
At the same time, the international backdrop has improved.
With the United States' economy recovering and global growth accelerating, what happens in Italy is seen as relatively insignificant. Bullish markets are now managing to see silver linings no matter how dire the country's situation gets.
That ignores the fact that Italy may not have a fully operative government for months and structural reform is off the table for the foreseeable future.
"The economy will suffer from the political gridlock and risks falling into a Greek-style depression if it is not rapidly resolved," said Mizuho's Barbieri.
The contrast with 2011 could hardly be greater. Then, acutely stressed markets ignored good news and jumped on any bad information to push Italy's yields ever higher.
Yet by virtually any measure other than bond yields, Italy's situation now is far worse than 18 months ago.
Its economy has contracted for six straight quarters - the longest recession for 20 years - and is smaller now, in inflation adjusted terms, than it was in 2001. That means that on average Italy has been in recession for 11 years, a situation that has no parallels in Europe and few in the world.
The slump shows no sign of easing and will continue to take a heavy toll on public finances. Credit for firms is still tightening and bad loans are rising.
When Fitch downgraded Italy on Friday it forecast the economy would shrink by 1.8 percent this year, following a 2.4 percent fall in 2012. Its industrial base has been so eroded in the last few years that many business people think it may never recover, with a huge cost in terms of jobs.
Analysts say all this has been at least partly due to the waves of austerity measures taken since early 2011 to calm markets and try to rein in the second largest public debt in the euro zone after Greece.
Yet while markets have calmed, Italy's debt keeps rising. It hit an all-time high of 127 percent of output in 2012 and Fitch forecast it will be almost 130 percent at the end of this year.
Markets ignored all this while the technocrat Mario Monti was in office, yet even he admitted his reforms to deregulate services and the jobs market were only a first step towards improving Italy's growth outlook.
And after a weak performance in last month's election Monti is gone, and no one knows what is coming next.
The election served up a perfect recipe for instability, with parliament split three ways between Pier Luigi Bersani's center-left, Silvio Berlusconi's center-right and the populist 5-Star Movement led by comedian Beppe Grillo.
Even if a coalition government can be formed quickly, which looks doubtful, the policy stances of the parties suggest it is very unlikely to pursue the sort of market-friendly policies attempted under Monti.
It may be that, with the ECB backstop in place, markets really don't care who governs Italy.
Draghi said at his monthly ECB news conference on Thursday that much of its fiscal adjustment was now on "automatic pilot."
Mizuho's Barbieri said the remarks presenting Italy's stalemate as a normal part of democracy and playing down concerns, were "a political masterpiece, though whether they were credible is another matter".
Moec called Draghi's assertion an "overstatement", but said he probably meant that the 2013 budget has already been approved, so unless a new government immediately slashes taxes or hikes spending, this year's deficit is unlikely to rise much.
However, that can only refer to this year and in any case economists agree that Italy's debt sustainability is all about growth and has very little to do with fiscal adjustment.
Draghi may have meant that international constraints will prevent Rome from pursuing irresponsible fiscal policies, which may also be true. But it was not pursuing irresponsible fiscal policies in 2011 and its bond market still collapsed.
Even without such policies it would risk remaining in its trap of permanent near-recession and rising debt. What the ECB may have removed is the threat of contagion to other countries.
Giacomo Vaciago, economics professor at Milan's Cattolica University, said Italy was now protected from market assault, but the election gridlock still left its economic prospects in tatters.
"Italians, like Greeks, can't hurt the euro any more, we can only hurt ourselves and our children," he said.
(Additional reporting by Francesca Landini; editing by Anna Willard)