Capital formation is a concept used in

macroeconomics Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output (econ ...

national accounts National accounts or national account systems (NAS) are the implementation of complete and consistent accounting Scientific technique, techniques for measuring the economic activity of a nation. These include detailed underlying measures that ...

and

financial economics Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade".William F. Sharpe"Financial Economics", in Its co ...

. Occasionally it is also used in corporate accounts. It can be defined in three ways: *It is a specific statistical concept, also known as net investment, used in national accounts statistics,

econometrics Econometrics is an application of statistical methods to economic data in order to give empirical content to economic relationships. M. Hashem Pesaran (1987). "Econometrics", '' The New Palgrave: A Dictionary of Economics'', v. 2, p. 8 p. 8 ...

and macroeconomics. In that sense, it refers to a measure of the ''net additions'' to the (physical) capital

stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...

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 is the dynamic that motivates the pursuit of profit, involving the investment of money or any financial asset with the goal of increasing the initial monetary value of said asset as a financial return whether in the form ...

, 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 Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating Old English word , which is from an ...

drives, setting up

financial institution A financial institution, sometimes called a banking institution, is a business entity that provides service as an intermediary for different types of financial monetary transactions. Broadly speaking, there are three major types of financial ins ...

s, fiscal measures, public borrowing, development of

capital market A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers ...

privatization Privatization (rendered privatisation in British English) can mean several different things, most commonly referring to moving something from the public sector into the private sector. It is also sometimes used as a synonym for deregulation w ...

of financial institutions, development of

secondary market The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. The initial sale of ...

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. Instead, it originated in credit-based economic growth during the 1990s and 2000s, which was accompanied by the rapid growth of the financial sector, and consequently the increased use of finance terminology in economic discussions.

Use in national accounts statistics

In the national accounts (e.g., in the

United Nations System of National Accounts The System of National Accounts or SNA (until 1993 known as the United Nations System of National Accounts or UNSNA) is an international standard system of concepts and methods for national accounts. It is nowadays used by most countries in the w ...

and the European System of Accounts
''gross capital formation''
is the total value of the

gross fixed capital formation Gross fixed capital formation (GFCF) is a component of the expenditure on gross domestic product (GDP) that indicates how much of the new value added in an economy is invested rather than consumed. It measures the value of acquisitions of new or ...

(GFCF), plus net changes in inventories, plus net acquisitions less disposals of valuables for a unit or sector. "Total capital formation" in national accounting equals net

fixed capital In accounting, fixed capital is any kind of real, physical asset that is used repeatedly in the production of a product. In economics, fixed capital is a type of capital good that as a real, physical asset is used as a means of production which i ...

investment, plus the increase in the value of

inventories Inventory (British English) or stock (American English) is a quantity of the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying ...

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 US, statistical measures for capital formation were pioneered by

Simon Kuznets Simon Smith Kuznets ( ; rus, Семён Абра́мович Кузне́ц, p=sʲɪˈmʲɵn ɐˈbraməvʲɪtɕ kʊzʲˈnʲets; April 30, 1901 – July 8, 1985) was a Russian-born American economist and statistician who received the 1971 Nobe ...

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 The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of las ...

(IMF) and the

World Bank The World Bank is an international financial institution that provides loans and Grant (money), grants to the governments of Least developed countries, low- and Developing country, middle-income countries for the purposes of economic development ...

have been influential in revising the system.

Different interpretations

The use of the terms "capital formation" and "

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

" can be somewhat confusing, partly because the concept of

capital Capital and its variations may refer to: Common uses * Capital city, a municipality of primary status ** Capital region, a metropolitan region containing the capital ** List of national capitals * Capital letter, an upper-case letter Econom ...

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

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 UN Trade and Development (UNCTAD) is an intergovernmental organization within the United Nations Secretariat that promotes the interests of developing countries in world trade. It was established in 1964 by the United Nations General Assembl ...

), 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 become wealthier, 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

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 stock levels 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. The measures were intended to identify changes in the growth of ''physical'' wealth across time. 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. The most recent alterations in national accounts standards mean that capital measures and many other measures are no longer fully comparable with the data of the past, except where the old data series have been revised to align them with the new concepts and definitions. US government statisticians have admitted frankly that "Unfortunately, the finance sector is one of the more poorly measured sectors in national accounts". The main reason is that national accounts were at first primarily designed to capture changes in tangible physical wealth, not financial wealth (in the form of financial claims).

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 (CFC) is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process ...

(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. Because of government tax-incentives and valuation issues, depreciation charged by businesses is rarely a true reflection of the loss in value of their capital stock. Hence, statisticians often revalue actual depreciation charges according to data about asset values and average service lives of assets, in order to obtain measures of true "economic depreciation".

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 A lease is a contractual arrangement calling for the user (referred to as the ''lessee'') to pay the owner (referred to as the ''lessor'') for the use of an asset. Property, buildings and vehicles are common assets that are leased. Industrial ...

agreement. Finally, the rate at which the value of the fixed asset depreciates will affect the gross and net valuation of the asset, yet different methods are typically used to value what assets are worth and how fast they depreciate. 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 or OMV (open market valuation) 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 t ...

*business value, assuming a certain profit yield *value for tax purposes, *value for insurance purposes *

purchasing power parity Purchasing power parity (PPP) is a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries' currency, currencies. PPP is effectively the ratio of the price of a market bask ...

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 A tax is a mandatory financial charge or levy imposed on an individual or legal person, legal entity by a governmental organization to support government spending and public expenditures collectively or to Pigouvian tax, regulate and reduce nega ...

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 In accountancy, depreciation refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...

Consumption of fixed capital Consumption of fixed capital (CFC) is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process ...

. Also, price

inflation In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

may affect the value of the capital stock. In

, 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 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. A precise distinction between "new" and "used" assets becomes more difficult to draw. How to value used assets and their depreciation consistently becomes more problematic. The general trend in accounting standards is for assets to be valued increasingly at "current market value", but this valuation is by no means absolutely clear and uncontroversial. It might be understood to mean the price of the asset if it was sold at a balance date, or the current replacement cost of the asset, or the average price of the asset type in the market at a certain date, etc.

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 A price index (''plural'': "price indices" or "price indexes") is a normalized average (typically a weighted average) of price relatives for a given class of goods or services in a specific region over a defined time period. It is a statistic ...

, 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 The circular flow of income or circular flow is a economic model, model of the economy in which the major exchanges are represented as flows of money, Good (economics), goods and Service (economics), services, etc. between economic agents. The f ...

). 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, any more than individuals "own" the public sector. James M. 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 In economics, a durable good or a hard good or consumer durable is a good that does not quickly wear out or, more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks could be conside ...

. 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." *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 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 Japa

In December 2012, managed funds statistics compiled by the NZ Reserve Bank indicated that New Zealanders have 49.8% of their

KiwiSaver KiwiSaver is a New Zealand savings scheme which has been operating since 2 July 2007. Participants can normally access their KiwiSaver funds only after the age of 65, but can withdraw them earlier in certain limited circumstances, for example if ...

money invested overseas. These managed fund figures include capital contributions, capital gains and losses and dividends and interest received.Brian Gaynor, "Wrong decisions send our savings overseas." ''New Zealand Herald'', 8 December 201

/ref> 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 loan, 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 US, 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 The ''McKinsey Quarterly'' is a business magazine focused on management and organizational theory. Background The magazine is written primarily by McKinsey consultants and alumni, with contributions from guest authors. Founded in 1964, it ...

, only "tangible" assets in US territory. The total value of ''marketable'' financial assets in the USA was estimated in 2007 at about US$46 trillio

This total obviously does not include assets, deposits and reserves that are not traded. The data series on national wealth provided in the budget annex were discontinued by the administration of President Barack Obama).

References

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