• Over the next two years, the recovery will strengthen as global GDP rises by 3.6 and 3.9 per cent; world trade will increase by 9.9 and 6.9 per cent.

• China will continue to grow at an extraordinarily fast rate, with GDP rising by 10.1 and 8.9 per cent in 2010 and 2011.

• The recovery in the US — growth of 2.4 and 2.6 per cent — will outpace that of the Euro Area, where GDP will rise by 1.0 and 1.7 per cent.

• Japan's national output will increase by a meagre 0.8 per cent this year, picking up to 1.8 per cent in 2011.

• The economy will grow by 1.1 and 2.0 per cent over the next two years.

• After its recent pause, unemployment will rise again, to 9.2 per cent in 2011.

• The surge in inflation this year will be temporary and CPI inflation will average 1.7 per cent in 2011.

• Public borrowing in 2013–14 will be 1.3 percentage points higher than the Treasury is forecasting and net debt as a share of GDP will not start to fall in 2015–16.

When protection is discussed people normally have policies designed to restrict imports in mind. But the way in which the international economy has been affected by toxic financial assets issued in the United States suggests that countries might face problems not only because of the goods and services trade but also because of the financial assets they import. Thus, in discussing the case for protection, we consider first whether there is a case for protection to prevent economies importing some types of financial instrument and, secondly, whether there is a case for more traditional protection as a way of resolving the global imbalances of the world economy. We conclude that financial protection is a sensible way for countries to protect themselves from risky assets if the production and testing of such assets is not regulated internationally.

The second quarter of 2009 marked the end of the global recession, and we estimate that global GDP increased by 1 per cent. However, the revival reflected growth in only a handful of economies, and was driven by a rise in domestic demand in an even smaller collection of countries. Government spending in mainland China, as well as Hong Kong, Taiwan and South Korea, was the driving force behind the rebound in global GDP. The recovery broadened to the majority of economies in the third quarter of last year, with particularly strong growth in Mexico, Brazil, Lithuania, Romania and Slovakia, as well as the Asian economies. Output continued to fall in the UK, Spain, Greece and several of the EU's new member states in the third quarter of 2009. Supported by highly expansionary fiscal and monetary policies, a sharp turn in the inventory cycle and external demand from Asia, the recovery has not yet spread to investment and consumer spending in many countries.

The forecasts for the world and the UK economy reported in this Review are produced using NIESR's model, NiGEM. The NiGEM model has been in use at the National Institute for forecasting and policy analysis since 1987, and is also used by a group of about 50 model subscribers, mainly in the policy community. Most countries in the OECD are modelled separately, and there are also separate models of China, India, Russia, Hong Kong, Taiwan, Brazil, South Africa, Estonia, Latvia, Lithuania, Slovenia, Romania and Bulgaria. The rest of the world is modelled through regional blocks so that the model is global in scope. All models contain the determinants of domestic demand, export and import volumes, prices, current accounts and net assets. Output is tied down in the long run by factor inputs and technical progress interacting through production functions, but is driven by demand in the short- to medium-term. Economies are linked through trade, competitiveness and financial markets and are fully simultaneous. Further details on the NiGEM model are available on http://nimodel.niesr.ac.uk/.

The North American economies are expected to recover pre-crisis levels of output earlier than most of their European counterparts. The resilience of these economies is partly a reflection of factors underlying the trend rate of capacity growth. Population projections in North America are favourable for medium-term growth prospects, partly due to policies that tend to encourage highly skilled inward migration. At the same time, the US is one of few countries that maintained strong productivity growth during the downturn (at a significant cost in terms of employment), allowing an increase in US productivity levels relative to the other major economies. In addition, the relatively rapid recovery expected in the North American economies reflects more aggressive fiscal policies in the US and Canada than in most European economies, as well as credit easing undertaken by the Federal Reserve, which has kept corporate borrowing costs low relative to levels in the UK and Euro Area. Canada and Mexico have also benefitted from the recovery in the oil price, which eases budgetary pressures in particular.

The revival in global growth in the second quarter of last year can be traced to a sharp rise in domestic demand in mainland China, as well as Hong Kong, Taiwan and South Korea. While GDP increased in Germany, France and Japan as well, growth in these economies relied on a rise in external demand, whereas domestic demand in these countries continued to decline. The rise in Asian domestic demand has been strongly supported by a series of fiscal packages. The scope of stimulus packages introduced in the larger Asian economies dwarfs the size of packages introduced in most European economies, averaging 4–5 per cent of GDP.

The deepest, longest and most broadly-based recession the European Union has ever experienced appears to have come to an end. The third quarter of 2009 saw GDP in the EU increase by 0.3 per cent and economic activity in the Euro Area rose by 0.4 per cent. The recovery is expected to be broadly based across countries. After deep contractions registered in 2009 in all members of the EU (with the exception of Poland), all but four EU economies are expected to have recorded some growth in the second half of 2009. Greece, Ireland, Spain and Latvia suffered more than other EU economies, due to their intrinsic vulnerabilities, which reinforced the negative impact of the global shock. These economies are expected to record only moderate positive growth in 2011.

The global economic downturn has led to a crisis in labour markets, with an estimated 15.2 million job losses across the OECD economies, equivalent to a rise in the OECD unemployment rate from 5.5 to 8.9 per cent. Initially, the rise in unemployment appeared lower than expected. In Holland, Kirby and Whitworth (2009) we demonstrated a simple rule of thumb between output growth and the unemployment rate in the OECD as a whole, based on Okun's approach. Using a dataset that spans the period 1988–2008, regression analysis suggests that on average a 1 per cent decline in output is associated with a rise of 0.6 percentage points in the unemployment rate across the OECD economies. Between the first quarter of 2008 and the first quarter of 2009, output in the OECD economies declined by 4.8 per cent. The unemployment rate rose by 1.9 points over this period, as compared to 2.9 per cent given by the rule of thumb. However, the labour market tends to lag production. While most of the major economies started to grow again in the second or third quarters of 2009, OECD unemployment continued to rise into the final quarter of the year, with a cumulative increase in the OECD unemployment rate of 3.4 percentage points — even higher than that suggested by our rule of thumb.

The preliminary estimate of GDP confirms that the UK economy finally stopped contracting in the fourth quarter of 2009, bringing to an end six quarters of continuous contraction (figure 1) but 0.1 per cent growth is disappointing. The estimate suggested that the economy contracted by 4.8 per cent in 2009. Growth was driven by the distribution and government sectors. The main contributors from the distribution sector were the retail and motor trades. This is consistent with the impact of the cut in the standard rate of VAT and the car scrappage scheme, both of which should have brought durables purchases forward into the last quarter of 2009. It also highlights the risk that, as the fiscal stimulus ends, the UK economy could stall and possibly even contract for a quarter or two. As figure 1 shows, we do not expect this to happen. We expect growth of 1.1 per cent per annum this year; stronger growth is inconsistent with a household sector undergoing a period of retrenchment and increased savings. Contributions to economic growth are expected to be the result of the inventory cycle and the influence of net trade.

The old trend of ever smaller amounts of government debt maturing and being retired gracefully is passing. In its place, a boom in issuance as a consequence of the recent crisis will lead to a youthful increase in the amount of maturing debt that requires settlement. The UK has the advantage, relative to some other countries in the Euro Area, of being able to issue longer-term debt (see figure 1), which helps avoid the so-called ‘roll over’ risk associated with maturing debt. By contrast, the long period of surpluses run by the Spanish government caused them to obtain over 75 per cent of recent funding from short-term markets.

The downturn in global economic activity that started in 2008 was turned into a major recession after the failure of Lehman Brothers in September 2008. It appears that world output fell by more than 1 per cent in 2009, and OECD output probably fell by around 3½ per cent. The effects on output were more marked in the Euro Area and the UK than they were in the US or Canada, which partly reflects the policy responses chosen by Treasuries and Central Banks. The financial crisis that drove the recession affected banks in the US, the UK, the Euro Area and the rest of Europe rather more than it did those in Canada, Australia and Japan. However, recessions have been common, with only Australia and Poland appearing to avoid them. The financial crisis led rapidly to a freezing of trade credit, which caused world trade to decline very sharply at the beginning of 2009. The financial crisis also led to an increase in risk premia in investment decision-making and hence to a decline in the equilibrium capital output ratio, which caused a sharp reduction in the demand for capital goods. Combined with credit rationing effects for firms needing access to borrowing, this induced a collapse in investment. Trade channels made the crisis global, as did movements in exchange rates. Interest rates were cut sharply in the US, Europe and Japan, and approached levels seen in Japan for the previous decade. As a result the yen appreciated strongly, and the combination of the effects of this appreciation on competitiveness and the decline in investment goods trade meant that Japan suffered worse than most other countries, at least in the short term.

The recent Sub-Prime crisis has prompted a close focus on the causes of financial instability as well as the issue of whether it can be prevented. There is a growing realisation that the Sub-Prime crisis, although having some important unique features, also had a number of generic aspects in common with earlier financial crises, of which a large number have been seen in recent decades. Accordingly, the crisis has prompted a debate about macroprudential policy, which focuses on the financial system as a whole, treating aggregate risk as endogenous with regard to collective behaviour of institutions. Our survey shows that a great deal of progress has been made in ‘macroprudential surveillance’ and related research on causes and predictors of crises. Much less progress has been made in ‘macroprudential regulation’, the design and implementation of policies to prevent or mitigate threatened crises.

Banking and finance are inherently pro-cyclical, a condition exacerbated by a combination of Basel II and mark-to-market accounting. But these latter measures have many advantages, so the need is to devise other counter-cyclical macro-prudential policies. This fragility was further enhanced by a decline in bank liquidity (reliance on wholesale funding) and a shift in govenance from partnerships to limited liability public companies. Some commentators have seen the solution to such pro-cyclicality in the guise of direct constraints on bank activity, such as the promotion of ‘narrow banking’ or limits on bank size. While there are arguments for toughening regulation as systemic risk increases, direct constraints are simplistic; more sensible ideas involve the adoption of better designed macro-prudential regulation, perhaps with some version of banking self-insurance. Quite what the future holds for bank regulation remains, however, to be decided.

With the advent of EMU, monetary policy can no longer be used to prevent housing market bubbles in regional economies such as Ireland or Spain. However, fiscal policy can and should be used to achieve the same effect. This paper shows that the advent of EMU relaxed existing financial constraints in Ireland and Spain, allowing a more rapid expansion of the housing stock in those countries to meet their specific demographic circumstances. However, the failure to prevent these booms turning into bubbles did lasting damage to the two economies, damage that could have been avoided by more appropriate fiscal policy action.

This paper describes research that integrates Keynesian and Walrasian economics in a new way. The author develops a model in which high unemployment can persist and any unemployment rate can occur as an equilibrium. Equilibrium is selected by the self-fulfilling beliefs of asset market participants. Using this new framework, the author argues that fiscal policy is not the best solution to the problem of restoring full employment. A policy of asset market management, similar to quantitative easing, is put forward as a more effective approach.

The financial crisis that started in the summer of 2007 and worsened in the autumn of 2008 has involved a repricing of risk and a reduction in the level of potential output in the OECD of between 3 and 5 per cent. In addition it has caused a major recession, leaving output gaps in the UK, the US and the Euro Area currently standing at 3 to 5 per cent of potential GDP despite active policy responses. We show that monetary policy (and especially quantitative easing) has increased output growth in the US and the UK by half a per cent in 2009, and will do the same in 2010Q1. Fiscal policy is also shown to have been effective, but we argue that more could have been done if unfounded worries about excess borrowing had not arisen.