It now seems increasingly likely that within the next few days Portugal will have to seek a £70bn bailout from the European Union and International Monetary Fund. That is bad news for Portugal, for Spain, for the euro and, indirectly, for the UK too. The crisis has come to a head with the resignation of Portugal's prime minister José Sócrates, after his minority administration failed to receive support from opposition parties for yet more tax rises and spending cuts. Failure to approve the austerity measures threatens to push high government borrowing to unaffordable levels. That would make Portugal the third eurozone nation, after Greece and Ireland, to be forced to apply for outside help.
The situation highlights a dilemma which stretches well beyond Portugal's shores. Most politicians there oppose harsher austerity. They have already raised taxes and implemented the deepest spending cuts in more than three decades.
To cut too far and too fast, they have argued, in an echo of the Labour party's stance in the UK, risks falling into a downward recessionary spiral as Ireland has.
Mr Sócrates believes that the only way to keep the ratings agencies happy is a tough deficit-reduction programme and a gamble on growth. But that does not look a risk-free strategy, as George Osborne has found with the independent Office for Budget Responsibility forecasting that growth here would be slower this year and next, than it thought last October.
In addition, high-street spending fell by 0.8 per cent last month as consumer confidence was walloped by the increase in VAT, rising petrol prices and general economic sluggishness. Recovery will be painfully slow or may be seriously delayed. The Portuguese dilemma is further compounded by the risk of falling foul of the bond markets and ratings agencies. Austerity measures will be even tougher, Mr Sócrates warned yesterday, if the IMF were brought in.
The other big risk is that the Portuguese contagion could spread to neighbouring Spain where the rating agency Moody's has just downgraded 30 smaller Spanish banks. On the same day Moody's warned that the UK's coveted AAA rating could be at risk if growth remains sluggish. Spain is in a significantly better position than Portugal but the possibility of a run on a country is always present when markets are panicky.
Europe's political leaders, who gathered yesterday for a "whatever it takes to save the euro" summit in Brussels, know that well enough. The euro dropped to a low of $1.4049 on news of the resignation of Mr Sócrates – whose austerity measures were backed by the EU and European Central Bank – though the currency recovered a little yesterday. No wonder the German Chancellor Angela Merkel has urged all parties in Portugal to get behind the austerity programme.
But Portugal's biggest party, the Social Democrats, while paying lip service to the need to reduce the deficit, will not back more cuts. Things can only get worse now that a political crisis has been added to the economic one. Lisbon's main stock market index fell by almost 1 per cent on Wednesday, though it rallied yesterday. The cost of insuring against a default on Portuguese sovereign debt rose. Portugal faces redemptions of £18bn of bonds in the next six months. Meanwhile people have begun to vent their frustration on the streets.
From Britain's point of view, any inclination to draw comfort from our non-membership of the euro would be a mistake. Apart from the fact that our 13.5 per cent commitment to the European Stability Mechanism fund could land us with a £3bn bill if Portugal defaults, our own growth-led recovery relies on boosting exports to our biggest market – the eurozone.