Financial markets face a tense start to the week, as they wait to see whether Greece’s sparring politicians can work together in a national unity government and whether Italy can reassure nervous investors that it will push ahead with fresh austerity measures.

After bitter negotiations overnight, Greek political leaders agreed to forge a coalition government in an attempt to prove to Europe that the country is determined to push ahead with tough austerity measures in order to avoid a messy default.

After an hour-long meeting, Greek Prime Minister George Papandreou and his rival Antonis Samaras, from the conservative New Democracy party, announced they had agreed on a new coalition government to approve the latest €130 billion ($US 179 billion) Greek bailout.

But the two sides were unable to agree on a candidate to lead the new coalition government, and will hold further discussions later today. Papandreou — the scion of one of Greece’s leading political families — will step down once there is a new team in place. According to a report in the Greek newspaper To Vima, the new government will be headed by Lucas Papademos, a former head of the European Central Bank.

Last week, German Chancellor Angela Merkel and French President Nicolas Sarkozy decided to withhold an €8 billion aid payment as Greece’s growing political turmoil raised doubts as to whether Athens would implement the tough budget cuts and economic reforms that it agreed to in exchange for its €130 billion bailout deal.

If the Greek government doesn’t get the money soon it will struggle to pay pensions and salaries for government workers at the end of the month, and the country is expected to default on a debt repayment in mid-December. Investors are worried that this default would constitute a “credit event” that would trigger credit default swaps, and could potentially throw financial markets into disarray.

Athens was desperate to have a new government in place today, in time for a meeting of eurozone finance ministers in Brussels, which is expected to discuss whether Greece should receive its €8 billion aid payment. On Sunday, the country was given 24 hours to form a unity government that could approve the bailout agreement.

According to opinion polls published in Greek newspapers on the weekend, around 80% of Greeks want to remain in the eurozone while just over 10% favour a return to the drachma. But confidence in the country’s political leadership has collapsed.

Meanwhile, Italian Prime Minister Silvio Berlusconi, bowing to pressure from Merkozy (as the duo of Merkel and Sarkozy has come to be called), has agreed to let the International Monetary Fund monitor his planned budget cuts and economic reforms.

But financial markets were unnerved after Berlusconi ruled out an IMF loan, even though the country’s borrowing costs are soaring. Yields on Italian 10-year bonds are now at 6.4%, a euro-era high, and close to the level at which Greece, Ireland and Portugal were forced to accept bailouts.

Investors are watching on nervously as Rome and Athens grapple with the tough political obstacles to pushing ahead with budget cuts and economic reforms at a time when their economies are already very fragile.

The risk is that further budget cuts cause government revenues to shrivel, and that government budget deficits continue to climb. At the same time, labour market reforms will cause unemployment queues to swell further.

Investors fret that we are now reaching the point where it is politically impossible for Rome and Athens to enact further austerity measures.

*This article was originally published at Business Spectator