Some £30bn has been wiped from the FTSE in recent days, and it lost a further 1 per cent of its value yesterday as European policymakers again failed to reassure markets that the "contagion" could be contained. The crisis could push Europe, including the UK, into a "double dip" recession. In foreign exchange markets, the euro slumped to its weakest level against the dollar since May, and its weakest level against the yen for more than a year.
Although Britain is not in the eurozone, a number of observers have pointed out that the UK's public finances are scarcely healthier than those of much-maligned Greece. Last week, the Tory leader, David Cameron, explicitly pointed to the parallels between Greece and the UK as justification for his plan to make an early, if modest, start on reducing the budget shortfall. The world's biggest bond fund, Pimco, last month warned that UK bonds were "resting on a bed of nitroglycerine".
And British banks face a near-£100bn exposure to these floundering European economies, threatening to tear another hole in their enfeebled balance sheets. Shares in banks throughout the European Union have been the hardest hit. Spain's Banco Santander, owner of Abbey, Bradford and Bingley and Alliance and Leicester, has lost 16 per cent of its value; Lloyds Group shed almost 5 per cent yesterday. Colin Ellis, of Daiwa Securities, said: "This week has seen the return of risk aversion, with a vengeance."
Greek government bonds and the Athens stock market have been mauled, and now attention has turned to Portugal and Spain. Demand for Portuguese government bonds was reportedly exceptionally weak yesterday, as the government's budget was defeated in parliament. Opposition MPs instead passed their own bill that will permit the country's autonomous regions to rack up even more debt.
The Spanish Prime Minister, Jose Zapatero, told reporters during a visit to President Barack Obama in Washington that Spain's economy is "fundamentally sound", words that usually act as cue for dealers to press the sell buttons. Mr Zapatero added: "This is not an easy moment; there are fundamental economic challenges of great magnitude for Spain and other countries."
The slide in confidence was triggered last Wednesday when the Spanish government revised its borrowing targets upwards, amid rumours that one of the leading ratings agencies would downgrade Spanish government debt. Spain, like Greece and Ireland, has announced austerity measures to cut the budget deficit, but, in all the nations, the policies are set on a collision course with the unions and other interest groups. Greek tax officials went on strike on Thursday.
The Greek Finance Minister, George Papaconstantinou, acknowledged the possibility that problems in some smaller economies could engulf the entire continental economy. This is why the Greek issue, despite its particular Greek characteristics, is also a eurozone issue. Markets have proved resistant to arguments from the Greek government that they are the victims of speculators with an "ulterior motive" to destroy the eurozone by picking on its "weak link". Greece has to raise a further €31bn (£27bn) over the next few weeks, a formidable challenge and the next crunch point.
The "domino effect", or contagion feared by analysts is now spreading rapidly through the so-called Pigs – Portugal, Ireland, Greece and Spain – the nations in the eurozone with the largest national debts and weakest public finances. They also suffer from distressingly high unemployment rates, up to 20 per cent in Spain, and long-term structural issues such as their ageing populations. Doubts persist that they will be able to service their huge budget deficits and the soaring interest burden on record-breaking national debts.
The possibility of default or, in an extreme scenario, a break-up of the eurozone is being openly discussed, though it is being resisted by all the governments concerned. Many doubt that the Pigs will be able to push through the tough economic and social reforms essential to restoring market confidence. The expectation is growing that Germany, France and other more solvent members of the currency bloc will be obliged to bail out the weaker links, and that the crisis will drag on until such a resolution is reached.
The panic is similar to the debt crisis of Dubai, which had to be rescued by its richer neighbour, Abu Dhabi. Since then, sovereign debt (securities and bonds issued by nation states) has been called "the new sub-prime", suggesting a rerun of the widespread damage that defaults on securities based on US mortgages caused in 2007. A similar downgrade and devaluation of European governments' bonds could also trigger a wider sell-off, and few believe UK gilts would be immune from the onslaught. That, in turn, would spell higher interest rates in Britain, adding hundreds of pounds a month to the average mortgage bill.
As with the original credit crunch, this second crunch would devalue bank balance sheets where they hold substantial stocks of government bonds, reducing the banks' ability to support lending into the real economy. That could lead to a "double dip" recession.
And signals are mixed about whether the German government would contemplate a bail-out of the Pigs. The German Economics Minister, Rainer Bruederle, told the Bundestag recently, to applause, that "some euro states are showing dangerous weakness ... This may have fatal effects on all states in the eurozone".
The EU has no formal process to deal with a national debt crisis, because it was never supposed to happen. The Maastricht Rules, framed in the 1993 treaty that laid the basis for the euro, were suspended early during the recession and have been widely flouted. The rules were also designed to reassure German voters who feared fiscal irresponsibility in some member states would leave them with huge bills for bail-outs. That now seems inevitable.
Joseph Stiglitz, the Columbia University professor and Nobel laureate, said: "The European Union should have a fund to help member nations in need of financial aid such as Greece. Deficit fetishism is a mistake."
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