Capital formation: Wikis

Advertisements
  
  

Note: Many of our articles have direct quotes from sources you can cite, within the Wikipedia article! This article doesn't yet, but we're working on it! See more info or our list of citable articles.

Encyclopedia

From Wikipedia, the free encyclopedia

Gross capital formation in % of gross domestic product in world economy

Capital formation is a statistical concept used in national accounts statistics, econometrics and macroeconomics. It is sometimes also used in corporate business accounts. It is a measure of the net additions to the (physical) capital stock in an accounting period, or, a measure of the amount by which the total physical capital stock increased during an accounting period; though it may occasionally also refer to the total stock of capital formed, or to the growth of this total stock.

In the national accounts (e.g. in the United Nations System of National Accounts and the European System of Accounts) gross capital formation is the total value of the gross fixed capital formation (GFCF), changes in inventories and acquisitions less disposals of valuables for a unit or sector.

Total capital formation equals fixed capital investment, 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 used for investment purposes, often investment in production.

In the USA, statistical measures for capital formation were pioneered by Simon Kuznets 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 IMF and the World Bank have been influential in revising the system.

In a much broader meaning or vaguer sense, capital formation is nowadays also used to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary financial markets. In this broader sense, 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 broader meaning is not related to the statistical measurement concept.

Contents

Different interpretations

The use of the term "capital formation" can be somewhat confusing, partly because the concept of capital 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 which is 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 which includes investment in all kinds of capital assets, whether physical property or financial assets.
  • Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not an accounting concept, 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 which cancels out (or more than cancels out) the gain in aggregate.
  • Thirdly, gross capital formation is often used synonymously with gross fixed capital formation but strictly speaking this is an error because gross capital formation refers to more assets than just fixed capital.

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 (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 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 become more complicated when a new fixed asset is acquired within some kind of lease agreement. Finally, the rate at which the value of the fixed asset depreciates 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 (acquisition) cost,
  • current replacement cost,
  • current sale or resale value,
  • average market value,
  • business value, assuming a certain profit yield
  • value for tax purposes,
  • value for insurance purposes
  • purchasing power parity 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 which are of a type 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 or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.

In national accounts, 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 would occur.
  • Capital expenditure must be distinguished from intermediate 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 which are 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, additions to the stock are added, and 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.

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). 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 incomplete on two counts.

  • Firstly, many larger corporations engage in corporate self-financing, i.e. financing from their own reserves, 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. Poterba (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.

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 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, 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 [1]. This total obviously does not include assets, deposits and reserves which are not traded).

See also

References

  • Literature and further information:
    • Eurostat: National accounts website
    • Eurostat: National Accounts - GDP, Statistics Explained.
    • Kuznets, Simon: "Proportion of capital formation to national product". American Economic Review, 1952.
    • Kuznets, Simon et al., National income and capital formation, 1919-1935. National Bureau of Economic Research, 1937.
    • Kuznets, Simon: Capital in the American Economy Princeton: Princeton University Press, 1961.
    • Kuznets, Simon: Commodity flow and capital formation. New York: National Bureau of Economic Research, 1938.
    • Kuznets, Simon: Gross capital formation, 1919-1933. New York: National Bureau of Economic Research, 1934.
    • Lequiller, F.; Blades, D.: Understanding National Accounts, Paris: OECD 2006, pp. 133-137
    • Malherbe, F.: Le site de la comptabilité nationale
    • Poterba, James: "Tax Policy and Corporate Saving", in Brookings Papers on Economic Activity, 2, 1987, pp. 455–503.
    • Ruggles, Richard; Ruggles, Nancy D.: National Income Accounts and Income Analysis. New York: McGraw-Hill, 1956.
    • Yanovsky, M.: Anatomy of Social Accounting Systems, London; Chapman & Hall, 1965.
    • "Analytical Perspectives" [2]
    • Review of Income and Wealth [3]
Advertisements

Advertisements






Got something to say? Make a comment.
Your name
Your email address
Message