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The Greek debt crisis has spread to Spain and Portugal in a dangerous escalation as global markets test whether Europe is willing to shore up monetary union with muscle rather than mere words.

Julian Callow from Barclays Capital said the EU may to need to invoke emergency treaty powers under Article 122 to halt the contagion, issuing an
EU guarantee for Greek debt. “If not contained, this could result in a
`Lehman-style’ tsunami spreading across much of the EU.”

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. The Madrid’s IBEX index fell 6pc.

Finance minister Elena Salgado said Professor Krugman did not “understand” the eurozone, but reserved her full wrath for the EU economics commissioner,
Joaquin Almunia, who helped trigger the panic flight from Iberian debt by
blurting out that Spain and Portugal were in much the same mess as Greece.

Mrs Salgado called the comparison simplistic and imprudent. “In Spain we have time for measures to overcome the crisis,” she said. It is precisely this
assumption that is now in doubt. The budget deficit exploded to 11.4pc last
year, yet the economy is still contracting.

Jacques Cailloux, Europe economist at RBS, said markets want the EU to spell out exactly how it is going to shore up Club Med states. “They are working
on a different time-horizon from the EU. They don’t think words are enough:
they want action now. They are basically testing the solidarity of monetary
union. That is why contagion risk is growing,” he said.

“In my view they underestimate the political cohesion of the EMU Project. What the Commission did this week in calling for surveillance of Greece has never
been done before,” he said.

Mr Callow of Barclays said EU leaders will come to the rescue in the end, but Germany has yet to blink in this game of “brinkmanship”. The core issue is
that EMU’s credit bubble has left southern Europe with huge foreign
liabilities: Spain at 91pc of GDP (€950bn); Portugal 108pc (€177bn). This
compares with 87pc for Greece (€208bn). By this gauge, Iberian imbalances
are worse than those of Greece, and the sums are far greater. The danger is
that foreign creditors will cut off funding, setting off an internal EMU
version of the Asian financial crisis in 1998.

Jean-Claude Trichet, head of the European Central Bank, gave no hint yesterday that Frankfurt will bend to help these countries, either through loans or a
more subtle form of bail-out through looser monetary policy or lax rules on
collateral. The ultra-hawkish ECB has instead let the M3 money supply
contract over recent months.

Mr Trichet said euro members drew down their benefits in advance -- "ex ante" -- when they joined EMU and enjoyed "very easy financing"
for their current account deficits. They cannot expect "ex post"
help if they get into trouble later. These are the rules of the club.