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Capital formation

Capital formation

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Capital formation is a concept used in macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, national accounts
National accounts
National accounts or national account systems are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting...

 and financial economics
Financial economics
Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....

. Occasionally it is also used in corporate accounts. It can be defined in three ways:
  • It is a specific statistical concept used in national accounts statistics, econometrics
    Econometrics
    Econometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...

     and macroeconomics. In that sense, it refers to a measure of the net additions to the (physical) capital stock
    Stock and flow
    Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time , which may have...

     of a country (or an economic sector) in an accounting interval, or, a measure of the amount by which the total physical capital stock increased during an accounting period. To arrive at this measure, standard valuation principles are used.
  • It is used also in economic theory, as a modern general term for capital accumulation
    Capital accumulation
    The accumulation of capital refers to the gathering or amassing of objects of value; the increase in wealth through concentration; or the creation of wealth. Capital is money or a financial asset invested for the purpose of making more money...

    , referring to the total "stock of capital" that has been formed, or to the growth of this total capital stock.
  • In a much broader or vaguer sense, the term "capital formation" has in more recent times been used in financial economics to refer to savings drives, setting up financial institution
    Financial institution
    In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...

    s, fiscal measures
    Fiscal policy
    In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

    , public borrowing, development of capital market
    Capital market
    A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...

    s, privatization
    Privatization
    Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...

     of financial institutions, development of secondary market
    Secondary market
    The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....

    s. In this usage, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways. This broadened meaning is not related to the statistical measurement concept nor to the classical understanding of the concept in economic theory.

Use in national accounts statistics


In the national accounts (e.g., in the United Nations System of National Accounts
United Nations System of National Accounts
The United Nations System of National Accounts is an international standard system of national accounts, the first international standard being published in 1953...

 and the European System of Accounts
European System of Accounts
The European System of Accounts is the system of national accounts and regional accounts used by members of the European Union. It was most recently updated in 1995 ....

) gross capital formation is the total value of the gross fixed capital formation
Gross fixed capital formation
Gross fixed capital formation is a macroeconomic concept used in official national accounts such as the UNSNA, NIPAs and the European System of Accounts . The concept dates back to the NBER studies of Simon Kuznets of capital formation in the 1930s, and standard measures for it were adopted in the...

 (GFCF), plus changes in inventories, plus acquisitions less disposals of valuables for a unit or sector.

"Total capital formation" in national accounting equals fixed capital
Fixed capital
Fixed capital is a concept in economics and accounting, first theoretically analysed in some depth by the economist David Ricardo. It refers to any kind of real or physical capital that is not used up in the production of a product and is contrasted with circulating capital such as raw materials,...

 investment, plus the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period (a year or a quarter). Capital is said to be "formed" when savings are utilized for investment purposes, often investment in production.

In the USA, statistical measures for capital formation were pioneered by Simon Kuznets
Simon Kuznets
Simon Smith Kuznets was a Russian American economist at the Wharton School of the University of Pennsylvania who won the 1971 Nobel Memorial Prize in Economic Sciences "for his empirically founded interpretation of economic growth which has led to new and deepened insight into the economic and...

 in the 1930s and 1940s, and from the 1950s onwards the standard accounting system devised under the auspices of the United Nations to measure capital flows was adopted officially by the governments of most countries. International bodies such as the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 (IMF) and the World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

 have been influential in revising the system.

Different interpretations


The use of the term "capital formation" and "investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

" can be somewhat confusing, partly because the concept of capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....

 itself can be understood in different ways.
  • Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital actually used for investment purposes and not held as savings or consumed. But in fact, in national accounts, the concept of gross capital formation refers only to the accounting value of the "additions of non-financial produced assets to the capital stock less the disposals of these assets". "Investment" is a broader concept that includes investment in all kinds of capital assets, whether physical property or financial assets. In its statistical meaning, capital formation does not include financial assets such as stocks and securities.

  • Secondly, capital formation may be used synonymously with the notion of capital accumulation
    Capital accumulation
    The accumulation of capital refers to the gathering or amassing of objects of value; the increase in wealth through concentration; or the creation of wealth. Capital is money or a financial asset invested for the purpose of making more money...

     in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not normally an accounting concept in modern accounts (although it is sometimes used by the IMF and the United Nations Conference on Trade and Development
    United Nations Conference on Trade and Development
    The United Nations Conference on Trade and Development was established in 1964 as a permanent intergovernmental body. It is the principal organ of the United Nations General Assembly dealing with trade, investment, and development issues....

    ), and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people get much wealthier, even although society as a whole becomes poorer, and the net capital formation decreases. In other words the gain could be a net total gain, or a gain at the expense of loss by others that cancels out (or more than cancels out) the gain in aggregate.

  • Thirdly, gross capital formation is often used synonymously with gross fixed capital formation
    Gross fixed capital formation
    Gross fixed capital formation is a macroeconomic concept used in official national accounts such as the UNSNA, NIPAs and the European System of Accounts . The concept dates back to the NBER studies of Simon Kuznets of capital formation in the 1930s, and standard measures for it were adopted in the...

     but strictly speaking this is an error because gross capital formation refers to more net asset gains than just fixed capital (it also includes net gains in inventory stocklevels and the balance of funds lent abroad).


Capital formation measures were originally designed to provide a picture of investment and growth of the "real economy" in which goods and services are produced using tangible capital assets. However, the international growth of the financial sector has created many structural changes in the way that business investments occur, and in the way capital finance is really organized. This not only affects the definition of the measures, but also how economists interpret capital formation.

Gross and net capital formation


In economic statistics and accounts, capital formation can be valued gross, i.e., before deduction of consumption of fixed capital
Consumption of fixed capital
Consumption of fixed capital is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets...

 (or "depreciation"), or net, i.e., after deduction of "depreciation" write-offs.
  • The gross valuation method views "depreciation" as a portion of the new income or wealth earned or created by the enterprise, and hence as part of the formation of new capital by the enterprise.

  • The net valuation method views "depreciation" as the compensation for the cost of replacing fixed equipment used up or worn out, which must be deducted from the total investment volume to obtain a measure of the "real" value of investments; the depreciation write-off compensates and cancels out the loss in capital value of assets used due to wear & tear, obsolescence, etc.

Technical measurement issues


Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing what the value of capital assets is. When a fixed asset or inventory is bought, it may be reasonably clear what its market value is, namely the purchaser's price. But as soon as it is bought, its value may change, and it may change even before it is put to use. Things often become more complicated to measure when a new fixed asset is acquired within some kind of lease
Lease
A lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...

 agreement. Finally, the rate the value of the fixed asset depreciates at affects the gross and net valuation of the asset, and different methods are typically used to value what assets are worth. Capital assets can for instance be valued at:
  • historic cost (acquisition cost)
  • current replacement cost
  • current sale or resale value
  • average market value
    Market value
    Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...

  • business value, assuming a certain profit yield
  • value for tax purposes,
  • value for insurance purposes
  • purchasing power parity
    Purchasing power parity
    In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...

     value
  • scrap value.


A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions. For any significant business, how assets are valued makes a big difference to its earnings and thus the correct statement of asset values is a perpetually controversial subject.

During an accounting period, additions may be made to capital assets (including those that disproportionately increase the value of the capital stock) and capital assets are also disposed of; at the same time, physical assets also incur depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....

 or Consumption of fixed capital
Consumption of fixed capital
Consumption of fixed capital is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets...

. Also, price inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 may affect the value of the capital stock.

In national accounts
National accounts
National accounts or national account systems are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting...

, there are additional problems:
  • The sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting
    Double counting (accounting)
    Double counting in accounting is an error whereby a transaction is counted more than once, for whatever reason. But in social accounting it also refers to a conceptual problem in social accounting practice, when the attempt is made to estimate the new value added by Gross Output, or the value of...

     would occur.

  • Capital expenditure must be distinguished from intermediate
    Intermediate consumption
    Intermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts , the US National Income and Product Accounts and the European System of Accounts .Conceptually, the aggregate "intermediate consumption" is equal to the amount of the...

     expenditure and other operating expenditure, but the boundaries are sometimes difficult to draw.

  • There exists nowadays a large market in second-hand (used) assets. In principle, statistical measures of gross fixed capital formation are supposed to refer to the net additions of newly produced fixed assets, which enlarge the total stock of fixed capital in the economy. But if a substantial trade occurs in fixed assets resold from one enterprise or one country to another, it may become difficult to know what the real net addition to the stock of fixed capital of a country actually is, to the extent that the precise distinction between "new" and "used" assets is more difficult to draw, and that how to value used assets and their depreciation consistently becomes problematic.

Perpetual Inventory Method


A method often used in econometrics to estimate the value of the physical capital stock of an industrial sector or the whole economy is the so-called Perpetual Inventory Method (PIM). Starting off from a benchmark stock value for capital held, and expressing all values in constant dollars using a price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

, known additions to the stock are added, and known disposals as well as depreciation are subtracted year by year (or quarter by quarter). Thus, an historical data series is obtained for the growth of the capital stock over a period of time. In so doing, assumptions are made about the real rate of price inflation, realistic depreciation rates, average service lives of physical capital assets, and so on. The PIM stock values can be compared with various other related economic variables and trends, and adjusted further to obtain the most accurate and credible valuation

Controversy


According to one popular kind of macro-economic definition in textbooks, capital formation refers to "the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion" (see Circular flow of income
Circular flow of income
In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers...

). The idea here is that individuals and governments save money, and then invest that money in the private sector, which produces more wealth with it. This definition is however inaccurate on two counts:
  • Firstly, many larger corporations engage in corporate self-financing, i.e., financing from their own reserves and undistributed profits, or through loans from (or share issues bought by) other corporations. In other words, the textbook definition ignores that the largest source of investment capital consists of financial institutions, not individuals or households or governments. Admittedly, financial institutions are, "in the last instance", mostly owned by individuals, but those individuals have little control over this transfer of funds, nor do they accomplish the transfer themselves. Few individuals can say they "own" a corporation, anymore than individuals "own" the public sector. James M. Poterba
    James M. Poterba
    James Michael "Jim" Poterba is an American economist, Mitsui Professor of Economics at the Massachusetts Institute of Technology, and current NBER president and chief executive officer.- Early years :...

     (1987) found that changes in corporate saving are only partly offset (between 25% and 50%) by changes in household saving in the United States. Social accountants Richard Ruggles and Nancy D. Ruggles established for the USA that "almost all financial savings done by households is used to pay for household capital formation - particularly, housing and consumer durables. On net, the household sector channels almost no financial savings to the enterprise sector. Conversely, almost all the capital formation done by enterprises is financed through enterprise savings - particularly, undistributed gross profits." (cited from Edward N. Wolff, "In Memoriam: Richard Ruggles 1916-2001", in: Review of Income and Wealth, Series 47, Number 3, September 2001, p. 414).

  • Secondly, the transfer of funds to corporations may not result in increased output or economic expansion at all; given excess capacity, a low rate of return and/or lacklustre demand, corporations may not in fact invest those funds to expand output, and engage in asset speculation instead, to obtain property income that boosts shareholder returns. To illustrate, New Zealand's Finance Minister Michael Cullen stated (NZ Herald, 24 February 2005) that "My sense is that there are definite gains to be made, both economic and social, in increasing the savings level of New Zealanders and in encouraging diversification in assets away from the residential property market." This idea is based on a flawed understanding of capital formation, ignoring the real issue - which is that the flow of mortgage repayments by households to financial institutions is not being used to expand output and employment on a scale that could repay escalating private sector debts. In reality, more and more local income and assets are appropriated by foreign share-holders and creditors in North America, Europe, Australia and Japan http://www.converge.org.nz/watchdog/.


The concept of "household saving" must itself also be looked at critically, since a lot of this "saving" in reality consists precisely of investing in housing, which, given low interest rates and rising real estate prices, yields a better return than if you kept your money in the bank (or, in some cases, if you invested in shares). In other words, a mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

 from a bank can effectively function as a "savings scheme" although officially it is not regarded as "savings".

Example of capital estimates


In the 2005 Analytical Perspectives document, an annex to the US Budget (Table 12-4: National Wealth, p. 201), an annual estimate is provided for the value of total tangible capital assets of the USA, which doubled since 1980 (stated in trillions of dollars, at September 30, 2003):

Publicly owned physical assets:
Structures and equipment . . . . . . $5.6
Federally owned or financed . . . $2.2
Federally owned . . . . . . . . . . .$1.0
Grants to state and local govt . . . $1.0
Funded by state and local govt . . . $3.3
Other federal assets . . . . . . . . $1.4

Subtotal (1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.9 trillion

Privately owned physical assets:
Reproducible assets . . . . . . . . $28.7
Residential structures. . . . . . . $12.4
Nonresidential plant & equipment . $11.8
Inventories . . . . . . . . . . . . $1.5
Consumer durables . . . . . . . . . $3.1
Land . . . . . . . . . . . . . . . $10.2

Subtotal (2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $38.9 trillion

Education capital:
federally financed . . . . . . . . . $1.4
financed from other sources . . . . $44.0

Subtotal (3) . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . $45.4 trillion

Research and development capital:
federally financed R&D . . . . . . . $1.1
R&D financed from other sources . . $1.7

Subtotal (4). . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .$2.9 trillion

TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . $94.1 trillion

Net claims of foreigners on US . . . . . . . . . . . . . . . . . $4.2 trillion

Net wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .$89.9 trillion

(Note: these data obviously do not include financial assets, such as estimated by the McKinsey Quarterly
McKinsey Quarterly
The McKinsey Quarterly is a business magazine focusing on management and organizational theory. It has been edited and published by the management consultancy McKinsey & Company since 1964 and appears quarterly with one special issue per year....

, only "tangible" assets in US territory. The total value of marketable financial assets in the USA was estimated in 2007 at about US$46 trillion https://www.imf.org/external/np/speeches/2007/073107a.htm. This total obviously does not include assets, deposits and reserves that are not traded).

See also


  • Capital (economics)
    Capital (economics)
    In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...

  • Capital accumulation
    Capital accumulation
    The accumulation of capital refers to the gathering or amassing of objects of value; the increase in wealth through concentration; or the creation of wealth. Capital is money or a financial asset invested for the purpose of making more money...

  • Constant capital
    Constant capital
    Constant capital , is a concept created by Karl Marx and used in Marxian political economy. It refers to one of the forms of capital invested in production, which contrasts with variable capital...

  • Consumption of fixed capital
    Consumption of fixed capital
    Consumption of fixed capital is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets...

  • Debt
    Debt
    A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

  • Double counting (accounting)
    Double counting (accounting)
    Double counting in accounting is an error whereby a transaction is counted more than once, for whatever reason. But in social accounting it also refers to a conceptual problem in social accounting practice, when the attempt is made to estimate the new value added by Gross Output, or the value of...

  • Equity investment (in finance and investment)
  • Factoring (finance)
    Factoring (finance)
    Factoring is a financial transaction whereby a business job sells its accounts receivable to a third party at a discount...

  • Financial capital
    Financial capital
    Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....

  • Fixed capital
    Fixed capital
    Fixed capital is a concept in economics and accounting, first theoretically analysed in some depth by the economist David Ricardo. It refers to any kind of real or physical capital that is not used up in the production of a product and is contrasted with circulating capital such as raw materials,...

  • Gross fixed capital formation
    Gross fixed capital formation
    Gross fixed capital formation is a macroeconomic concept used in official national accounts such as the UNSNA, NIPAs and the European System of Accounts . The concept dates back to the NBER studies of Simon Kuznets of capital formation in the 1930s, and standard measures for it were adopted in the...

  • Human capital
    Human capital
    Human capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...

  • Initial public offering
    Initial public offering
    An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...

  • Investment-specific technological progress
  • Privately held company
    Privately held company
    A privately held company or close corporation is a business company owned either by non-governmental organizations or by a relatively small number of shareholders or company members which does not offer or trade its company stock to the general public on the stock market exchanges, but rather the...

  • Public company
    Public company
    This is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...

  • Reverse takeover
    Reverse takeover
    A reverse takeover or reverse merger is the acquisition of a public company by a private company so that the private company can bypass the lengthy and complex process of going public...

     (also known as a back door listing or reverse merger)
  • Social capital
    Social capital
    Social capital is a sociological concept, which refers to connections within and between social networks. The concept of social capital highlights the value of social relations and the role of cooperation and confidence to get collective or economic results. The term social capital is frequently...

  • Special-purpose acquisition company (SPAC)