• The world economy is starting to pick up speed again: by 2003, it will be growing by 3.7 per cent, with world trade expanding by 8.5 per cent a year.

• This will prompt rises in interest rates in North America and Europe.

• The US will grow by 2.4 per cent this year, double the rate of last year, rising to 3.5 per cent in 2003.

• Recovery in the euro area will be gradual, with GDP growth rising from 1.4 per cent in 2002 to 2.5 per cent in 2003.

• The Japanese economy will shrink by 1.2 per cent in 2002, and recovery in 2003 will be relatively modest, with GDP growth of 1.3 per cent.

It increasingly appears that the decline in global economic activity that set in during the latter half of 2000 has started to come to an end. Trade levels have begun to rise modestly, consumer and business confidence have strengthened and the present accommodative stance of macroeconomic policies is clearly having a positive impact on demand in many of the major industrialised economies, especially in North America. Global economic activity is now estimated to have risen by 2.4 per cent last year on a PPP basis, approximately half a percentage point more than previously thought. This upward revision largely reflects the strength of domestic demand within many developing economies, with growth remaining especially strong in China and India and also in several other transition economies. In contrast, the volume of international trade in 2001 appears to have been largely unchanged from a year earlier, as we have predicted for some time.

The US economy has proved to be considerably more resilient than had been widely expected in the immediate aftermath of the events of 11 September last year. Although these did cause some short-term disruption to the economy as a whole, GDP rose by 0.4 per cent in the fourth quarter of last year, more than offsetting the decline in output in the third quarter. Forward looking indicators, such as business and consumer confidence and equity markets, have all picked up since that time. Recent data suggest that growth has accelerated further since the start of this year, and it appears likely that GDP will have risen by at least 1 percentage point in the first quarter. If the current recovery is sustained, the recent recession will have proved to be the mildest on record.

GDP in the Euro Area fell by 0.2 per cent in the final quarter of 2001, the first quarterly decline since 1993. With the notable exception of Spain, output declined or stagnated in all the Euro Area economies that have published GDP figures for the fourth quarter. Germany and Austria experienced a technical recession in the latter half of last year, with two consecutive quarters in which output declined. Outside the Euro Area, Sweden and Denmark both recorded modest growth in the final quarter of the year. In the case of Sweden this stemmed from a weakening of the currency against the euro, while Danish growth was supported by an expansion in government expenditure. The widespread downturn in the Euro Area resulted from further contractions in corporate expenditure. Private sector investment and inventory accumulation made a negative contribution to output growth in 2001 as a whole; in contrast consumers' expenditure remained relatively resilient, especially in France and Spain. Trade contracted markedly towards the end of the year, especially in Germany and France. Export and import volumes in the Euro Area both declined by 0.6 per cent in the final quarter of the year. For the year as a whole, net trade made a strong positive contribution to growth, reflecting exceptionally weak import demand in Germany, France, Italy, the Netherlands, Belgium and Finland.

Ahead of the official data, we anticipate only slow growth in the first quarter of this year. GDP stagnated in the fourth quarter of 2001, with continued growth in the service sector being offset by a sharp contraction of 2.2 per cent in industrial production. It appears increasingly likely that this was just a temporary pause. Whilst growth is expected to be faster later in the year, as shown in chart 1, the relatively poor performance at the turn of the year and lower projections for government spending growth this year mean that we now expect only a 1.8 per cent rise in GDP in the year as a whole, below the bottom end of the range projected by the Treasury in the recent Budget forecast. The risk of the green shoots of recovery failing to consolidate remains as a downside risk to our central forecast.

There is now mounting evidence to suggest that positive rates of growth have been restored early this year, but the recovery is likely to be somewhat slower than we had anticipated in January. Our early estimates of monthly GDP suggest that growth in the first quarter was 0.2 per cent. The pattern of monthly GDP suggests that the stagnation in economic growth which began in September last year continued into the first month of 2002, contributing to the weak rate of growth estimated for the first quarter.

The UK has to make a decision on membership of EMU in the next two years. The monetary and fiscal regimes in the Euro Area and in the UK do not differ greatly. However, we argue that membership of EMU will increase the stability of the economy and the credibility of the policy framework, and hence will enhance the prospects for growth and higher incomes and employment. There appear to be no major problems associated with joining EMU at around 1.50 euros to the pound, although there are risks to the UK if the euro appreciates against the dollar after we have entered. However, the costs associated with this risk have to be offset against the probability of the significant output gains that could come from EMU membership in the medium term.

For most of the postwar period both labour and total factor productivity growth in the EU was higher than in the US. The 1990s witnessed a change in this trend with the US experiencing higher growth rates for the first time in decades. This was partly due to the end of catch-up growth as many larger EU Member States had reached US levels by the beginning of the decade with also some evidence of a higher ‘New Economy’ impact in the US. The productivity record of the UK was poor relative to its major European competitors throughout most of the postwar period, although this relative decline appears to have come to an end. This paper presents figures on relative productivity for the total EU and individual Member States in the 1990s. Both postwar convergence and trends in the 1990s are discussed in terms of a number of factors which result in the emergence of differences across European countries. These include the skill composition of the workforce, the rate of introduction of new technology and the institutional environment in which firms operate. The latter include the stability of the macroeconomic environment and aspects of competition and regulation. The paper concludes that trends in productivity largely reflect long-term structural aspects but that EMU membership might have a small favourable effect on UK productivity.

The UK is commonly viewed as having a ‘market oriented’ financial system, in contrast to other European countries which are seen as ‘bank dominated’. In the light of this supposition, we investigate sectoral balance sheet data for evidence of differences in financial structure between the UK and other major EU countries. It is found that the UK has much in common with Continental countries, in particular France, and they are themselves markedly heterogeneous. There is also some evidence of convergence towards a more market-oriented financial system, even in the most bank-dominated economy, Germany.

At the heart of the evaluation of the economic costs and benefits of adopting the euro lies the question of whether living standards would be higher outside or inside the Euro Area. It is well established that there is a strong positive relationship between openness to international trade and investment and the performance of the UK economy. European integration is continuing to help raise the openness of the UK economy, as well as stimulating product market competition and making the UK a more attractive location for mobile investments. This provides an additional channel through which potential output in the UK is linked to the degree of integration with the rest of Europe. Adopting a common currency may bring modest further gains to productivity and living standards by stimulating trade as well as competition. Reducing exchange rate volatility may also raise the level of fixed capital investment in the UK, although the direct evidence for this is limited, and stimulate inward investment from outside Europe, but could reduce the level of foreign direct investment between the UK and the Euro Area. However it is far from clear how big the net benefits might be or how soon they might start to appear. If the UK were to enter monetary union at a significantly overvalued real exchange rate the gains might never materialise at all and there could easily be significant net losses.