Eastern Europe
Factors in transition

Many recent studies of the Central and East European countries (CEECs) focus on how policy can hasten or hinder their catch-up with the OECD economies, but most assume that their factor endowments and hence the end-points of their transitions are fixed. In Discussion Paper No. 796, Programme Director Richard Baldwin and Research Fellow Anthony Venables develop a stylized framework to assess how factor mobility in the transition can affect the long-run equilibrium outcome. Human and physical capital are complements, so foreign capital inflows affect skilled labourers' wages, their migration decisions and hence the long-run level of human capital, whose current and future stock affects returns to foreign investment. The CEECs' long-run factor `endowments' are therefore not predetermined: their long-run per capita income levels depend on their long-run average skill level, their capital/labour ratio and the commodity composition of their trade, which depend in turn on the particular labour, capital and technology flows that characterize their transition.

Baldwin and Venables extend this model to show that externalities entailed in absorbing foreign capital and matching it to the CEECs' stocks of skilled labour create the possibility of `vicious' and `virtuous' transition paths. Under the first, the CEECs' best and brightest expect only small inflows of Western capital and technology and head West, while Western factors expect all the CEECs' talented managers, engineers and scientists to leave and therefore remain in the West. Under the second, emigration is low, Eastern wages rise sharply and there are large inflows of foreign investment and technology transfers. Multiple rational expectations adjustment paths open the door to self-fulfilling expectations and `chaotic' effects, with small policy changes leading to large changes in the long-run equilibrium, so the market-based equilibrium transition path is not socially optimal. Such concerns are magnified if human capital has beneficial externalities and there are multiple equilibrium paths, in which case governments must implement policies to avert the `vicious' equilibria.

International Migration, Capital Mobility and Transitional Dynamics
Richard Baldwin and Anthony J Venables

Discussion Paper No. 796, June 1993 (IT)