Fears grow that Irish economy will befall same fate as Greece

Country's budget deficit now worst in the developed world

Ireland edged closer to default yesterday as her government said the already crippling cost of rescuing her banking system had risen to almost €50bn (£43bn). The latest bank bailouts mean that Ireland's budget deficit will explode from 11 per cent to 32 per cent of her national income this year – three times that of the UK, some 10 times the EU's guideline, and the highest among the world's developed economies.

The announcement, by the Finance minister, Brian Lenihan, that Ireland's financial woes were even worse than thought has reignited fears of a repeat of May's "contagion" when the financial crisis in Greece spread to the vulnerable economies of Spain, Portugal, Italy and Ireland, sending the cost of borrowing in those nations spiralling. Then, as now, investors are assessing the growing risk that a eurozone member will default on its debts – a calamity for the EU. Mr Lenihan had to spend half-an-hour on the phone to fellow European finance ministers trying to reassure them there is "no question" that Ireland will have to seek external help, saying the nation is "fully funded".

Ireland's total national debt is almost 100 per cent of GDP, compared to 55 per cent in Britain, and at a level many economists regard as unsustainable.

Moody's, the last credit rating agency to give Spain a top AAA credit rating, downgraded Madrid's debts to AA, a move that underlined the fragility of the recovery across the eurozone's peripheral economies. A Spanish general strike on Wednesday and continent-wide protests also demonstrated how difficult it may be for governments to push through austerity packages. The danger being identified by investors is that successive rounds of cuts in public spending and tax hikes only serve to weaken economies, push budget deficits higher and weaken banks still further as dole queues lengthen, house prices collapse and bad debts mount up.

If the next round of austerity cuts promised by Brian Cowen's government does fail, then Ireland would have no alternative but to approach the EU and IMF for a bailout, an indignity so far only suffered by Greece, which has drawn €110bn from the joint EU/IMF fund. That would also infect the standing of the EU more generally, and leave Ireland permanently worse off as her financial reputation suffers. From being in the position of enjoying some of the highest living standards in Europe, Ireland might slip back into the kind of deprivation and emigration that characterised life before the 1990s.

While the very integrity and future of the single currency is not in the same sort of jeopardy as it seemed earlier this year, the news from Ireland and Spain helped push the euro down on the foreign exchanges, and shares in the Irish banks tanked.

A vicious deflationary cycle appears perilously close in Ireland, which posted a 1.2 per cent contraction in her economy in the second quarter. Public sector workers are facing cuts in salaries of between 5 and 15 per cent, and thousands face the sack. Meanwhile investors are demanding record-breaking interest for lending to the Irish government; it costs Dublin almost 7 per cent in interest to tempt buyers to take on a 10-year government bond, against about 3 per cent for an equivalent German government bond, though both are denominated in euros.

The immediate cause of the latest crisis to hit the former "Celtic Tiger" stems from the appalling cost of keeping her banks afloat, and in particular Anglo Irish Bank. Mr Lenihan said the bill for recapitalising that institution alone had risen to about €40bn, much worse than had been feared. As with the rest of Ireland's banks, but in a more extreme fashion, Anglo Irish both relied too heavily on wholesale international money markets – which dried up during the credit crunch – and lent too readily into the property market. An official investigation into Anglo Irish bank by PricewaterhouseCoopers revealed it had 15 customers who owe the bank more than €500m each, money that will never be recovered.

So far, the Irish state has had to guarantee the deposits of her banks and building societies and nationalise or part-nationalise some. The Irish government also announced that a further €3bn will be needed to prop up the Allied Irish Banks group, which leaves it majority state–owned, and $2.7bn for the Irish Nationwide Building Society.

For now, markets appear willing to give Ireland some benefit of the doubt, especially as the government has raised most of the money it needs to get through this financial year. Ben May, European Economist at Capital Economics, said: "This might raise some hope that Ireland is taking decisive and transparent steps to address the problems in its banking sector. But with the continued weakness of the economy raising clear doubts over the government's ability to meet its deficit reduction goals, worries that Ireland will ultimately be forced to restructure its debts are unlikely to subside in the foreseeable future."