Today’s severe turbulence in the European equity markets is a renewed reminder of just how flawed the euro project has (as was always predictable) turned out to be, but the extent to which it spread today was also a reminder of why Greece is most unlikely to be allowed to fail. For the clear market signal today was that if Greece goes, others too may be next for the chopping block, and “contagion” will be well and truly back on the scene.

Over at the Daily Telegraph, Ambrose Evans-Pritchard turns his gloomy attention to Portugal and Spain:

Credit default swaps (CDS) measuring bankruptcy risk on Portuguese debt surged 28 basis points on Thursday to a record 222 on reports that Jose Socrates was about to resign as prime minister after failing to secure enough votes in parliament to carry out austerity measures. Parliament minister Jorge Lacao said the political dispute has raised fears that the country is no longer governable. “What is at stake is the credibility of the Portuguese state,” he said.
Portugal has been in political crisis since the Maoist-Trotskyist Bloco won 10pc of the vote last year. This is rapidly turning into a market crisis as well as investors digest a revised budget deficit of 9.3pc of GDP for 2009, much higher than thought. A €500m debt auction failed on Wednesday. The yield spread on 10-year Portuguese bonds has risen to 155 basis points over German bunds. Daniel Gross from the Centre for European Policy Studies said Portgual and Greece need to cut consumption by 10pc to clean house, but such draconian measures risk street protests. “This is what is making the markets so nervous,” he said. In Spain, default insurance surged 16 basis points after Nobel economist Paul Krugman said that “the biggest trouble spot isn’t Greece, it’s Spain.” He blamed EMU’s one-size-fits-all monetary system, which has left the country with no defence against an adverse shock.

Professor Krugman is right. As that is the case and as there is no realistic way in which an economically weak country could junk the euro, the only alternatives are truly savage budgetary austerity, default, or significant external support. If domestic political considerations make the former unfeasible and the fragility of the financial markets makes the second unthinkable, that really only leaves the third alternative — bailout.