First Athens, now Dublin. Will Lisbon and Madrid follow?

As the EU and its central bankers try to persuade Ireland to accept aid, fears rise for other weak eurozone states
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The Abbey Theatre is in final rehearsals for Freefall ahead of Tuesday's opening of the production named best new play at the Ulster Bank Theatre Festival.

Across O'Connell Bridge, politicians and financiers are battling to save Ireland's banks from freefall. If terms cannot be agreed, Dublin's troubles may transfer to mainland Europe.

Ireland knows it must accept a European bail-out, but it is playing a game of bluff. Despite dire financial difficulties, ministers and bankers have one strong card in their hand – the rest of Europe needs a solution even more than Dublin does.

The EU and the European Central Bank are not negotiating to save Ireland, they are negotiating to save themselves. If the Irish Republic cannot repay its debts, it will be its creditors in Britain, Germany and other larger nations that lose. And if Dublin defaults, the next domino to fall could be Portugal with the risk that Spain becomes the next target.

So there is an impasse this weekend. Ireland has refused to make a formal request for help and EU, IMF, and ECB officials who are already in Dublin cannot force it to accept an offer.

And all around them, as they gaze from the headquarters of the Bank of Ireland and the Department of Finance towards O'Connell Bridge, is the tangible evidence of the country's problems. Office blocks are unfinished and unlet; empty flats await buyers. Ireland is suffering the aftermath of a boom based on property and values are tumbling.

Dublin house prices fell by 25 per cent in the past year according to the Permanent TSB bank and are now half their peak values; the 17 per cent one-year decline outside the capital is little better. Land values have plunged further, but the properties are unsaleable because banks cannot lend to buyers.

In the heady days before the crash, two-thirds of first-time buyers purchased property by borrowing 90 per cent or more of the price. Their equity has been wiped out but the lenders face massive losses too. The government has spent €23bn (£20bn) nationalising Anglo Irish Bank and billions more to take control of Allied Irish Bank and to buy 36 per cent of Bank of Ireland. Those sums are dwarfed by the liquidity lent by the country's central bank. But having rescued the banks, the government itself now needs rescuing.

If this were simply a domestic affair, the rest of Europe might be content to let Ireland suffer. The country knew decades of poverty before it joined the EU in 1973, and its initial gains led to the 1980s financial crisis when unemployment reached 20 per cent and taxes soared. Only then did the government impose the measures that allowed Ireland to become the high-growth Celtic tiger.

Ironically for a country now looking for EU financial aid, EU money fuelled the boom that encouraged banks to lend so freely. In the late 1990s, annual growth averaged 10 per cent and it was still 4.7 per cent when the crisis struck in 2007. But Ireland was the world's first country to go into recession. It emerged this year but after one quarter of growth the economy has shrunk again and if the figure out next month is negative too, it will be back in recession. Unemployment has risen to 13.6 per cent and retail sales have steadily fallen.

But Ireland's problems are not restricted to the island. The main lenders to the Dublin government are not Irish but German and British. Allied Irish Bank has a €4.2bn sovereign debt exposure and Bank of Ireland €1.2bn, but Hypo Real Estate is owed €10.3bn and Royal Bank of Scotland €5bn. The German government had to nationalise Hypo after the crash and the UK government owns 84 per cent of RBS, so if Dublin cannot pay its debts, British and German taxpayers will suffer directly. The UK's HSBC and Credit Agricole of France are big lenders too.

That is one reason why Britain's Chancellor, George Osborne, considered a straight loan to Dublin, pointing out Ireland's importance as a trading partner – bigger than Brazil, Russia, India and China combined.

Britain is not a member of the eurozone, but the Bank of England is a shareholder in the European Central Bank, which has provided liquidity to Dublin. As a contributor to the IMF, London will be liable for 4.5 per cent of any aid it gives too. It is also liable for 12 per cent of the European Financial Stability Fund (EFSF) established during the Greek crisis this spring.

Ireland will be offered a package of up to €80bn by those agencies at rates much lower than the near 9 per cent Irish government bonds reached last week. Sean Murphy, the deputy chief executive of Chambers Ireland, representing 13,000 of the country's businesses, says: "It is critical that the interest paid on future government debt falls as paying rates of 7 per cent plus will not be financially sustainable".

A suggestion by the German Chancellor, Angela Merkel, that bondholders take a haircut and receive only part-repayment on troubled countries' debts has only pushed rates higher as investors fear losses. Anglo Irish Bank will tomorrow reveal the reaction to its plan to pay investors just 20 per cent of junior bonds' face value.

The Irish finance minister, Brian Lenihan, says that his government needs no new borrowing until next summer but his country's three big banks must refinance €6bn of loans before March, when borrowers will be competing in a congested market – UK banks alone need to raise £250bn.

The Portuguese government needs to find €20bn next year too. Its bond rate soared last week and the EU and IMF team negotiating in Dublin this weekend know that at stake is not only Ireland's financial future but those of other weak countries' too.

Kathleen Brooks, a director at Gain Capital, a currency trader, says: "A bespoke solution to Ireland's crisis is only kicking the can of peripheral financial worms further down the street. Until there is a convincing automatic default mechanism for all eurozone members, we could see other flare ups."

Alistair Darling, Britain's former chancellor, who agreed the UK's support for the EFSF just before the election, thinks the Greek experience should have taught governments to act more decisively. Bill O'Neill, the chief investment officer of Merrill Lynch Wealth Management in Europe, agrees: "One lesson that should have been learnt in the spring of 2010 is that the cost of procrastination is excessive."

The worry is that, after travelling from Athens to Dublin, the crisis will move to Lisbon and then Madrid. Ireland's population is just 4.5 million, so each euro of aid costs Germany or France cents . Portugal has 11.3 million people but Spain has 46 million, with debts to match. As the problem moves from small countries to large, there are fewer contributors and more seeking aid. Mr O'Neill warns: "If market yields for Spanish bonds rack up as fast as Ireland's have recently, the problem could quickly become so large as to overwhelm current structures".

But while some, especially eurosceptics, see Ireland's problems as the beginning of the euro's demise, practical considerations mean the single currency will survive. Not only do France and Germany remain politically committed to it, there is no realistic mechanism for a country to leave. For Ireland to abandon the currency it would have to redesignate all bank balances and shop prices overnight and have alternative notes and coins ready to exchange. And Dublin's own euro-denominated debt would become even more expensive to repay if its new currency devalued.

So the IMF and others must cobble together a formula that keeps Ireland in the euro but permits it to repay its debts. That means closing the country's budget deficit, which is forecast to reach 32 per cent next year. Details are due in Mr Lenihan's Budget, scheduled for 7 December. Ireland has already made €15bn of cuts on a gross domestic product of €156bn but another €15bn is likely.

Mr Murphy fears cuts may curtail future growth and its ability to earn its way out of its problems. "Economic strategy must focus on current spending and not on capital spending, which is vitally needed to sustain a functioning wider economy," he says.

There is particular concern that other European countries want Ireland to raise its 12.5 per cent corporation tax rate. The low rate has helped attract businesses such as Google, Microsoft and Pfizer to set up there. But Dublin ministers say corporate tax in not negotiable and the director-general of the Irish Business & Employers Confederation, Danny McCoy, warns: "Any change in the corporate tax regime would be counter productive. Higher rates would mean less revenue for the state."