Capital Formation

Capital formation is a term used in national accounts statistics and macroeconomics. It basically refers to the net additions to the (physical) capital stock in an accounting period, or, to the value of the increase of the capital stock; though it may occasionally also refer to the (growth of the) total stock of capital formed.

Thus, in UNSNA, capital formation equals fixed capital investment, the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period. Capital is said to be "formed" when savings are used for investment purposes, often investment in production.

Capital formation is often equated with, or used as an abbreviation for gross fixed capital formation but strictly speaking this is an error, since the latter is only a component of the former.

Contents
1 Origin of the concept
2 Different interpretations
3 Gross and net capital formation
4 Technical measurement issues
5 Perpetual Inventory Method
6 Controversy
7 Example of capital estimates
8 See also
9 References



[edit] Origin of the concept
In the USA, statistical estimates for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s, and from the 1950s onwards the standard accounting system devised to measure capital flows was adopted officially by the governments of most countries.


[edit] 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 saved or consumed. But in fact the concept refers only to the accounting value of the additions of assets to the capital stock less the disposals of assets; and often capital formation is used to refer only to investment in fixed assets, not investment in all types of assets. "Investment" 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, capital formation is often used synonymously with Gross fixed capital formation but strictly speaking this is an error, for two reasons: (a) capital formation as such can in principle refer to more assets than just fixed capital, and (b) capital formation can be stated "gross" (before deduction of depreciation write-offs or Consumption of fixed capital) or it can be stated "net" (after deduction of depreciation charges). So, capital formation could mean gross capital formation or net capital formation.
In a 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 broad 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.


[edit] Gross and net capital formation
In economic statistics and accounts, capital formation can be valued gross (without deductions for depreciation) or net (adjusted for 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.


[edit] 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. Capital assets can for instance be valued at:

historic (acquisition) cost,
current replacement cost,
current sale value,
average market value,
business value assuming a certain profit yield
value for tax 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.

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 is an additional problem, since 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.


[edit] Perpetual Inventory Method
A method often used in econometrics to estimate the value of the physical capital stock 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.


[edit] 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". 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 capital value drains to foreign share-holders and creditors.

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".


[edit] 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):