The past few weeks have seen an intensification of the banking crisis in the United States, with the near failure of Bear Sterns, although some commentators hopefully say that the worst has now passed. In the United Kingdom the gap between the Bank Rate and money market rates has re-opened and is described as indicative of a reluctance of banks to lend to each other. In this commentary we seek to explain the fundamental factors behind recent developments in UK lending markets. We begin by describing the recent experience of the financial services industry in the United Kingdom and putting the crisis, which has been described as the worst since the Second World War, into some sort of perspective.

A financial crisis, rooted in US mortgage defaults, has been building for several years. Its effects have seriously damaged the prospects for the global economy, and have particularly serious consequences for the English speaking world. Unsound lending permitted by poor regulation and worsened by lax bankruptcy laws has led the US, and potentially the rest of the OECD, to the brink of a large-scale recession. The scale of the potential slowdown depends upon the scale of losses to the banking system and their impacts on the ability of the banking system to lend.

Growth in the US appears to be slowing rapidly after an expansion of 4.8 per cent at an annual rate in the third quarter of 2007. As we can see from figure 5, growth dropped to almost zero per cent at an annual rate in the fourth quarter and we expect the rate to be negative in the first quarter of this year. The growth rate will be negative for the first time since the downturn in 2001, which, after data revision, no longer constitutes a technical recession.

The economies of East Asia, including Japan, ended last year strongly, despite the noticeable slowdown in the US and in Europe. Buoyed by a fiscal stimulus package, private consumption in Hong Kong is booming; domestic demand expanded at double digit rates on an annual basis in the final quarter of last year and the preliminary data for the first several months of this year show no abatement. Elsewhere, strong credit growth and healthy labour markets underpin investment and private consumption growth in South Korea and across the region in general. We expect output growth to moderate somewhat but to remain healthy this year in much of East Asia and Australia. GDP is forecast to expand by nearly 3 per cent per annum in Australia, down from a 3.9 per cent pace recorded last year. China is forecast to grow by over 10 per cent this year, down from an 11.3 per cent pace in 2007. Output growth in Taiwan is likewise expected to moderate to about 5¼ per cent on an annual basis.

In 2008 and 2009, real GDP growth in the Euro Area is forecast to settle in the 1½–1¾ per cent range, ¼ to ½ percentage points less than expected in January. The downward revision in part reflects the downgrading in world growth prospects, in particular for the US. Recent economic indicators for Euro Area countries indeed remain relatively favourable. The most recent early indicators available for the start of 2008 are also conducive to moderate optimism. At around 2½ per cent for HICP both in 2008 and 2009, inflation projections are a little above the January forecast due to the pass-through of higher oil prices on domestic costs. The impact of energy prices on overall inflation has however been mitigated by the euro's continued appreciation, which has also contributed to prospects for slower growth. The main downside risks to the current forecast are linked to the high energy prices and to how European banks will respond to spillovers from the US subprime crisis.

Crises have a common shape but not always common consequences, as Barrell and Davis (2005) discuss. Asset bubbles are associated with the run-up to most crises and regulators should respond, taking an asset bubble as a signal of a need for precautionary action. It is easy to say that fundamentals have changed an asset market, and hard to spot a bubble. It is also common to suggest that interest rate policy should be set to constrain bubbles such as those in housing markets in recent years. Not only is it difficult for the central bank to use interest rates to constrain a bubble, it is also inappropriate if inflation is under control. It is for the financial market regulator, which may or may not be in the central bank, to respond to the bubble and strengthen its precautionary measures designed to raise lending standards.

Over the past fifteen months oil prices have steadily risen from around $60 a barrel to over $100, as we can see from Figure 1. The projections in our forecast are based on information from futures markets and on projections by the US Energy Information Administration, and as prices have risen there has been increasing evidence that they are considered to be overshooting a sustainable position, as can be seen from our projections for oil prices. Oil prices are expected to fall back to $90 a barrel by the end of 2009. Hence the current oil price shock can be seen as a combination of a temporary increase and a permanent increase in oil prices. The impact of increases in oil prices on growth depends in part on the reasons for the increase, with the effects of supply reduction induced increases in prices being more negative than demand induced increases in prices. A supply reduction involves a loss of revenue for producers as compared to a fixed volume demand induced rise in oil prices, and hence a supply reduction would result in lower levels of imports by oil producers.

The UK economy has perhaps reached its most precarious position in over a decade because of global financial market developments. It is all but undeniable that GDP growth reached its zenith in 2007. The UK has been reasonably adept at weathering previous global storms over those ten years, partly through the fortuitous use of fiscal policy. However, the unfolding news on the current shocks to the UK economy suggests that they will be more difficult to offset than others seen since 1997.

Forecasters are often critised for failing to predict outcomes, and this criticism can be justified if they rely on point estimates in their forecasting rather than providing a measure of the uncertainty around their estimates. There are a number of ways to provide measures of uncertainty, but perhaps the most widely used involves the calculation of past forecast errors and hence the use of an outcome distribution based on those errors. Evaluating forecast uncertainty is particularly important at present as events in US and European financial markets have meant that a significant degree of judgement has to be utilised in order to produce a projection for the next two years. The scale of loses in the US mortgage and related markets are unknown, and the impacts of even an agreed set of losses are uncertain.

This paper seeks to provide a comprehensive overview of the long-term factors that explain divergent price levels across developed and emerging European countries. We provide stylised facts about the structural factors that influence market and non-market-based service, house and goods prices. The stylised facts show that there is much more behind differences in price levels among European countries than the much heralded Balassa-Samuelson effect and that prices other than those of market services are potential determinants of price levels and inflation rates in emerging Europe. Finally, we sketch out the possible mismatches between price level convergence and inflation rates.

In the present study we investigate the relationship between foreign ownership and innovation activities using the firmlevel data of the third Community Innovation Survey (CIS) covering twelve European countries. Probit estimates based on 28,000 firms' observations show that foreign-owned firms are more innovative than domestic firms, particularly in the New EU Member States. However, results from the Blinder-Oaxaca decomposition of the differences in the percentage of innovating firms between foreign-owned and domestic firms reveals that the differences are mainly due to the different firm characteristics rather than the differences in coefficients. In particular, the dominance of foreign-owned firms in the largest firm size group is the main factor contributing to the gap in the percentage of innovators between foreign-owned firms and domestic firms. Furthermore, using the fractional logit model, we find that in the New EU Member states, foreign ownership has a positive and significant impact on the share of market novelties as well as on the share of new products in turnover. In this case, the results from the Blinder-Oaxaca decomposition analysis indicate that the ownership difference in the share of innovative sales is not due to the differences in the observed firms' characteristics.

Estimation and simulation of sustainable real exchange rates in a sample of EU member countries find vulnerabilities connected to the adoption of the euro if the rate vis-à-vis the euro were to be fixed with weak fundamentals and inappropriate policies. Sample countries have benefited from dramatic improvements in their external positions, in part driven by inflows of foreign direct investment. As a result, exchange rate misalignments have narrowed in most countries and, looking ahead, are expected to narrow further. These results are conditional, however, on optimistic projections with respect to world import demand and foreign direct investment inflows.

The challenge for labour market policy in the new member states and other transition economies of Eastern Europe has been to redress the sharp drops in employment and rises in unemployment in a way that fosters the creation of productive jobs. This paper first documents the magnitude and productivity of job and worker reallocation. It then investigates the effects of privatisation, product and labour market liberalisation, and obstacles to growth in the new private sector on reallocation and its productivity in Hungary, Romania, Russia, and Ukraine. We find that market reform has resulted in a large increase in the pace of job reallocation, particularly that occurring between sectors and via firm turnover. Unlike under central planning, the job reallocation during the transition has contributed significantly to aggregate productivity growth. Privatisation has not only stimulated intrasectoral job reallocation, but the reallocation is more productive than that among remaining state firms. The estimated effect of privatisation on firm productivity is usually positive, but it varies considerably across countries. The productivity gains from privatisation have generally not come at the expense of workers, but are associated rather with increased wages and employment.

Membership in the monetary union imposes higher demands on factor market flexibility, since neither the exchange rate nor monetary policies can be used to deal with country-specific shocks. In this paper we assess the ability of the twelve new EU member states (NMS-12) to dampen the impact of shocks by means of macroeconomic wage flexibility. Following the structural VAR approach elaborated in Moore and Pentecost (2006), real wage flexibility is measured by the responsiveness of real wages to real (permanent) and nominal (temporary) shocks. The analysis of Moore and Pentecost (2006) is extended in three ways: by employing a new Eurostat labour cost data set covering 1996Q1 to 2007Q3, by using a large sample of 24 EU member countries, and by assessing the sensitivity of the results to the sample length. We find evidence of heterogeneous real wage adjustment across the new as well as the mature EU economies. Overall, the degree of real wage flexibility in the NMS-12 lies within the bounds of the corresponding values for the Euro Area ‘core’ and ‘peripheral’ member countries.