Romano Prodi has tonight resigned as Italian prime minister after losing a confidence vote in the Senate.
Mr Prodi's defeat will probably bring early elections, which polls suggest would return conservative Silvio Berlusconi to power.
But President Giorgio Napolitano may first appoint an interim government to reform Italy's messy electoral system.
Analysts said the demise of the 61st government since World War II should not hurt the economy, as Mr Prodi had been too busy surviving politically to carry out deep reforms.
They said they hoped for electoral reform to cure Italy's chronic instability. "This isn't necessarily bad news, it all depends what comes after Prodi," said Unicredit MIB economist Marco Valli.
"Markets don't like uncertainty but if what follows Prodi is a stronger government, then that could be positive." Mr Prodi's tenure was dogged by infighting in his centre-left coalition.
The final blow was the defection of a small Catholic party this week, which erased his tiny majority in the Senate and made a vote of no confidence almost inevitable.
The 68-year-old academic known as the "Professor", whose first spell as prime minister was cut short in 1998 when his communist allies deserted him, had warned senators that Italy "cannot afford a power vacuum" right now.
"Italy risks finding itself in a negative economic cycle which we will face with still imperfect economic structures," he told a rowdy debate, where one senator spat at another who was then carried out of the chamber on a stretcher.
Even the support of unelected lifetime senators could not save Mr Prodi, who won a confidence vote in the lower house yesterday but rejected the president's advice to quit before the Senate vote to avoid a beating. He lost by 156 votes to 161.
Even one of the prime minister's most acerbic critics, Senator Roberto Calderoli of the far-right Northern League, said he admired his pluck: "He will lose the confidence vote but he will fall with a soldier's honour for having fought to the end."
The centre-right opposition led by media magnate Mr Berlusconi, who lost to Mr Prodi in 2006 elections, hopes Mr Napolitano will now call early elections which, according to opinion polls, Mr Berlusconi would win by a clear margin.
But there is a groundswell of pressure for a reform of election rules, with which Mr Berlusconi tampered before the last elections and which are widely blamed for political instability.
Mr Prodi said he and Napolitano agreed on the need to "prevent Italy having to hold elections under the current electoral law". Mr Prodi, a former European Commission president, takes credit for starting to tidy up the public finances of the euro zone's third largest economy.
But Brussels fears Italy's finances may worsen in 2008 and that the budget will still not be balanced by 2011 as promised. Italian growth forecasts are being cut, industrial output is falling and consumer confidence at its lowest in 2-1/2 years. Analyst Tito Boeri said that while Mr Berlusconi is Italy's richest man, he may not be the best option for the economy.
Mr Prodi's record on tax evasion meant "his management of public finances was better than ... under Berlusconi", Mr Boeri said.