DP796 | International Migration, Capital Mobility and Transitional Dynamics

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International factor mobility implies that factor `endowments' of the Central and East European Countries (CEECs) are not pre-determined in the long run. Due to factor complementarity, there is a circular relationship between emigration and foreign investment: capital inflows boost the wages of human capital, thereby discouraging emigration, while a high skill level encourages foreign investment. Introducing an externality linking the cost of absorbing foreign capital and the stock of skilled labour creates the possibility of `vicious' and `virtuous' transition paths. The first entails the CEECs' best and brightest heading West because they expect little Western capital and technology to flow in, and the Western factors avoiding the CEECs since they expect all the talented managers, engineers and scientists to leave. The virtuous cycle involves little emigration and large amounts of foreign investment and technology transfer. These multiple rational expectations adjustment paths open the door to self-fulfilling expectations and `chaotic' effects (small policy changes leading to radical changes in the equilibrium).Our policy analysis finds that once there is international factor mobility, the market-based equilibrium transition path is not socially optimal. This holds even if there are no externalities or other distortions. These concerns are magnified if human capital has beneficial externalities and there are multiple equilibrium paths. In this latter case, the government has a clear incentive to take action to delete the `vicious' equilibrium.