• The economy will shrink by 4.3 per cent this year, and then experience a weak recovery, with GDP rising by 0.9 per cent in 2010.

• The unemployment rate will peak at 9.6 per cent in 2011.

• Consumer spending will fall by 3.7 per cent this year and a further 1.1 per cent in 2010.

• The recovery will be driven by net trade, which will contribute 1.2 per cent to GDP growth in both 2010 and 2011.

• The medium-term outlook for government finances is grim, with public sector net borrowing forecast at 8.6 per cent of GDP in 2013–14

• The global economy will contract this year by 0.5 per cent, its first annual decline since 1946.

• World trade will fall by 8.2 per cent in 2009.

• Among the G7, Japan and Italy will be the worst affected, with a 15 and 40 per cent chance, respectively, of the recession lasting 9 quarters or more.

• Fiscal and monetary easing since 2008 offset 1–1.6 percentage points of the potential declines in the G7 economies this year, except in Italy where fiscal stimulus has been minimal.

• Government bond spreads in the Euro Area have widened sharply since 2007, partly due to the sudden rise in government debt.

When the Government adopts a fiscal policy framework and target structure, as the current Government did in 1997, there is only limited interest in criticism of the policy framework itself. Inevitably much more attention focuses on whether the Government's targets will be met, rather than on whether those targets are the right targets; this is a simpler focus for debate.

The global financial crisis has been compounded by an exceptionally sharp drop in world trade, and we are now facing the most widespread global recession in over sixty years. World GDP is expected to record an annual decline this year for the first time since 1946. As the economic crisis has developed, policymakers have stepped in across the globe to help stabilise the world economy. In the absence of fiscal and monetary easing initiated since 2008, world output would have been expected to decline by 1.7 per cent this year, compared to our current forecast decline of 0.5 per cent. However, while policy actions in the banking sector were sufficient to stabilise what appeared to be the imminent collapse of the global financial system last October, there is little concrete evidence that policy initiatives have successfully started to ease lending conditions. The key risks to our forecast hinge on the speed with which financing conditions normalise, the speed with which world trade reverts to equilibrium and the path of inventories.

While US banks remain in a severe state of distress, there are now signs that the banking system has stabilised and is not expected to deteriorate further. Recovery, however, remains some way off. US authorities have been slow to address problems facing the asset side of bank balance sheets, as the election and presidential changeover delayed an immediate response. The Troubled Asset Relief Program (TARP) was initiated in October 2008, as part of the Emergency Economic Stabilization Act of 2008. The original purpose of the program was to fund government purchases of toxic banking assets. However, the policy was subsequently amended, so that the funds were primarily used to buy equity stakes in banks. While this was an efficient way to inject essential capital into the banking system to avoid a meltdown, it has done little to address the fundamental problems of the banking sector, as there remains enormous uncertainty surrounding the valuation of assets held by individual banks.

Asia's economic slowdown has proved unexpectedly sharp so far. Japan's GDP contracted by over 3 per cent on a quarter-on-quarter basis in the final quarter of last year, marking the third consecutive quarterly fall in output, and exported goods dropped by 40 per cent in the first quarter of 2009 from the same time last year. Taiwan's and Korea's falls in output were deeper still, with output declining in both countries by over 5 per cent on a quarter-on-quarter basis in the fourth quarter (over 20 per cent annualised). China's growth slowed to 6.1 per cent in the first quarter of 2009 relative to a year earlier, well below the Government's target of 8 per cent to maintain employment.

Recession in the Euro Area continues. The contraction in the fourth quarter of 2008 was much sharper than that observed in the previous quarter. The Euro Area economy shrank by 1.6 per cent on a quarterly basis as compared to a decline of 0.3 per cent in the third quarter of 2008. Early 2009 has seen further decreases in economic activity in the single currency block.

The recent downturn in economic activity has led to large-scale revisions to debt stock projections for all major economies. In this note we look at the projected evolution of debt stocks over the next decade, compare them to our pre-crisis projections from January 2008 and put uncertainty bounds around them. Increased debt stocks may increase the costs of borrowing by governments, and they appear to be a factor behind the increase in spreads on government bonds that we have observed in Europe in the past year or so. We analyse those spreads, and suggest that each excess rise of 34 per cent of GDP in government debt issued by members of EMU might, in the medium term, raise the cost of their borrowing by up to 100 basis points. We should be careful in extrapolating this to the UK situation, but there are lessons to be learnt.

The scale of the recession in the UK is striking. The preliminary estimate of GDP suggests that the economy contracted by 1.9 per cent in the first quarter of this year, following contractions of 0.7 per cent and 1.6 per cent in the third and fourth quarters of 2008 respectively (figure 1). The detailed data on output suggest that the recession is widespread; only agriculture and government services recording growth in the first quarter of this year. The first quarter of this year probably saw the sharpest quarterly contraction since the second quarter of 1980. In addition the peak to trough fall to date is greater than any recorded since the Quarterly National Accounts were first published in 1955. Box A presents NIESR's monthly GDP series, which allows us to provide a monthly dating of the recession. The box includes a monthly GDP series for the early 1930s, and hence we are able to compare the profile of this recession with that period as well as the recessions of the early 1980s and early 1990s. There is a striking similarity between the current recession and the depression starting in 1929, although we do not expect GDP to continue to follow the path of that contraction. We expect the UK economy to return to growth in the final quarter of this year. Part of this growth is because consumers are expected to bring forward expenditure before the standard rate of VAT is returned to 17.5 per cent in January 2010. We expect the UK economy to contract by 4.3 per cent this year, but our forecast is that output will grow throughout 2010, leaving that year 0.9 per cent above the level for 2009. Even with a growth rate of 2.3 per cent in 2011, we expect it to take until the second quarter of 2012 to recover the previous peak level of output seen in the first quarter of 2008. This means that the duration of the depression (defined as output depressed below its previous peak) will be similar to that of the 1930s and 1980s.

The global financial crisis has had significant effects both on the prospects for output growth and projections for government borrowing and debt. We project that the UK government debt stock will rise to around 100 per cent of GDP and that output will be permanently scarred by around 4–5 per cent. The first is much more pessimistic than government projections, whilst the second is similar. In this note we explain a sequence of revisions we have made to our projections for trend growth as the crisis has unfolded, and also look at medium-term projections for the fiscal position. Not all of the deterioration in the budget has come from revisions to output, and not all of the changes to trend output result from the crisis, but the two are crucially linked.

The successes of the first decade of European Economic and Monetary Union are impressive, but it is fair to stress these were achieved in a relatively benign economic environment characterised by steady global growth, supportive financial conditions and fiscal windfalls associated with booms in asset markets. Although all this has come to an abrupt end with the financial crisis, there is a silver lining of fiscal stimulus being more effective in EMU than without the single currency, with offsetting exchange rate responses absent, trade multipliers stronger and the fiscal framework credible. But the financial crisis also clearly demonstrated the need for stronger coordination of national policy actions to internalise cross-border spillovers. Meanwhile, the European Commission has a major role to play in striking the right balance between short-term emergency measures and longer-term priorities. Against this backdrop, this article sheds light on the longer-run challenges and the policy agenda for meeting them.

As the tenth anniversary of EMU is approaching, a debate is underway as to whether the single currency has promoted or hindered convergence among the countries of the Euro Area. On the one hand, there is wide agreement that asymmetric shocks have subsided after the creation of the single currency, but if one moves to examine the catching-up process between the more and less affluent countries of the Euro Area, the evidence is waning. Another worrying development in the Euro Area is the emergence of unprecedented current account deficits in the southern Euro Area countries, while the northern ones enjoy substantial surpluses. To counter these new imbalances, new well-framed policy priorities are required in the Euro Area that put more emphasis on convergence and competitiveness than before.

There is only a sparse literature on the determination of real exchange rate volatility, and little attention has been given to the possible impact of EMU on volatility of real exchange rates of EU countries. A number of papers suggest a negative impact of exchange rate volatility on investment or growth, for advanced as well as developing countries, although we note that price and wage adjustment that might link to real exchange rate volatility is also part of the adjustment mechanism to macroeconomic shocks in EMU. We assess whether an effect of EMU on conditional volatility of real effective exchange rates can be detected, both for EMU and non EMU members. We find that the advent of EMU was accompanied by a reduction in conditional real exchange rate volatility for most EMU countries, as well as Sweden and Denmark that did not join EMU, but did not lead to a reduction in real rate volatility for Germany, Belgium, the Netherlands, nor, outside EMU, for the UK.

To what extent is the Euro Area common business cycle affected by the inclusion of the UK into this group? To answer this question, a semi-structural model estimated by the Kalman filter, which is robust to outliers and structural breaks, is used. We look at the correlations between business cycles taking potential phase shifts into account. On the one hand, a finding — coherent with existing literature — is that adding the UK to the euro group lowers correlations within the group. On the other hand, the UK cycle is increasingly linked to the Euro Area business cycle and has statistical properties that do not differ substantially from the Euro Area cycles.

This paper develops a new approach for investigating the determinant of the mark-up of prices over costs. We estimate basic price equations around an expression for marginal cost that is derived from a cost minimisation problem, using a vector error correction approach to avoid endogeneity bias. Observed basic prices include the mark-up over marginal costs, and this mark-up is of interest to policymakers as an indicator of competition and ultimately as a determinant of the level of equilibrium employment. We look at the factors driving this mark-up, and in particular look at the role of EMU, as well as globalisation, the European Single Market and openness to trade and the introduction of the euro. We use a panel data set that includes both EMU and non-EMU members. The results indicate an important role for trade liberalisation in determining the mark-up, but openness itself and the introduction of the euro do not appear to have a significant role.