Capital

I INTRODUCTION

Capital, a collective term for a body of goods and monies from which future income can be derived. Generally, consumer goods and monies spent for present needs and personal enjoyment are not included in the definition or economic theory of capital. Thus, a business regards its land, buildings, equipment, inventory, and raw materials, as well as stocks, bonds, and bank balances available, as capital. Homes, furnishings, cars and other goods that are consumed for personal enjoyment (or the money set aside for purchasing such goods) are not considered capital in the traditional sense.

In the more precise usage of accounting, capital is defined as the stock of property owned by an individual or corporation at a given time, as distinguished from the income derived from that property during a given period. A business firm accordingly has a capital account (frequently called a balance sheet), which reports the assets of the firm at a specified time, and an income account, which reckons the flow of goods and of claims against goods during a specified period.

Among the 19th-century economists, the term capital designated only that segment of business wealth that was the product of past industry. A wealth that is not produced, such as land or ore deposits, was excluded from the definition. Income from capital (so defined) was called profit, or interest, whereas the income from natural resources was called rent. Contemporary economists, for whom capital means simply the aggregate of goods and monies used to produce more goods and monies, no longer make this distinction.

The forms of capital can be distinguished in various ways. One common distinction is between fixed and circulating capital. Fixed capital includes all the more or less durable means of production, such as land, buildings, and machinery. Circulating capital refers to nonrenewable goods, such as raw materials and fuel, and the funds required to pay wages and other claims against the enterprise.

Frequently, a business will categorize all of its assets that can be converted readily into cash, such as finished goods or stocks and bonds, as liquid capital. By contrast, all assets that cannot be easily converted to cash, such as buildings and equipment, are considered frozen capital.

Another important distinction is between productive capital and financial capital. Machines, raw materials, and other physical goods constitute productive capital. Claims against these goods, such as corporate securities and accounts receivable, are financial capital. Liquidation of productive capital reduces productive capacity, but the liquidation of financial capital merely changes the distribution of income.

II THEORIES OF CAPITAL

The 18th-century French economists known as physiocrats were the first to develop a system of economics. Their work was developed by Adam Smith and emerged as the classical theory of capital after further refinements by David Ricardo in the early 19th century. According to the classical theory, capital is a store of values created by labour. Part of capital consists of consumers’ goods used to sustain the workers engaged in producing items for future consumption. The part consists of producers’ goods channelled into further production for the sake of expected future returns. The use of capital goods raises labour productivity, making it possible to create a surplus above the requirements for sustaining the labour force. This surplus constitutes the interest or profit paid to capital. Interest and profits become additions to capital when they are ploughed back into production.

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Karl Marx and other socialist writers accepted the classic view of capital with one major qualification. They regarded as capital only the productive goods that yield income independently of the exertions of the owner. An artisan’s tools and a small farmer’s land holding are not capital in this sense. The socialists held that capital comes into being as a determining force in society when a small body of people, the capitalists, owns most of the means of production and a much larger body, the workers, receives no more than bare subsistence as reward for operating the means of production for the benefit of the owners.

In the mid-19th century the British economists Nassau William Senior and John Stuart Mill, among others, became dissatisfied with the classical theory, especially because it lent itself so readily to socialist purposes. To replace it, they advanced a psychological theory of capital based on a systematic inquiry into the motives for frugality or abstinence. Starting with the assumption that satisfactions from present consumption are psychologically preferable to delayed satisfactions, they argued that capital originates in abstinence from consumption by people hopeful of a future return to reward their abstinence. Because such people are willing to forgo present consumption, productive power can be diverted from making consumers’ goods to making the means of further production; consequently, the productive capacity of the nation is enlarged. Therefore, just as physical labour justifies wages, abstinence justifies interest and profit.

Inasmuch as the abstinence theory rested on subjective considerations, it did not provide an adequate basis for objective economic analysis. It could not explain, in particular, why a rate of interest or profit should be what it actually was at any given time.

To remedy the deficiencies of the abstinence theory, the Austrian economist Eugen Böhm-Bawerk, the British economist Alfred Marshall, and others attempted to fuse that theory with the classical theory of capital. They agreed with the abstinence theorists that the prospect of future returns motivates individuals to abstain from consumption and to use part of their income to promote production, but they added, in line with classical theory, that a number of returns depends on the gains in productivity resulting from accretions of capital to the productive process. Accretions of capital make production more roundabout, thus causing greater delays before returns are realized. The amount of income saved, and therefore the amount of capital formed, would accordingly depend, it was held, on the balance struck between the desire for present satisfaction from consumption and the desire for the future gains expected from a more roundabout production process. The American economist Irving Fisher was among those who contributed to refining this eclectic theory of capital.

John Maynard Keynes rejected this theory because it failed to explain the discrepancy between money saved and capital formed. Although according to the eclectic theory and, indeed, all previous theories of capital, savings should always equal investments, Keynes showed that the decision to invest in capital goods is quite separate from the decision to save. If investment appears unpromising of profit, saving still may continue at about the same rate, but a strong “liquidity preference” will appear that will cause individuals, business firms, and banks to hoard their savings instead of investing them. The prevalence of a liquidity preference causes unemployment of capital, which, in turn, results in unemployment of labour.

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III HISTORY OF CAPITAL

Although theories of capital are of relatively recent origin, capital itself has existed in civilized communities since antiquity. In the ancient empires of the Middle and the Far East and to a larger degree in the Graeco-Roman world, a considerable amount of capital, in the form of simple tools and equipment, was employed to produce textiles, pottery, glassware, metal objects, and many other products that were sold in international markets. The decline of trade in the West after the fall of the Roman Empire led to less specialization in the division of labour and a reduced use of capital in production. Medieval economies engaged almost wholly in subsistence agriculture and were therefore essentially non-capitalist. Trade began to revive in the West during the time of the Crusades. The revival was accelerated worldwide throughout the period of exploration and colonization that began late in the 15th century. Expanding trade fostered a greater division of labour and mechanization of production and therefore a growth of capital. The flow of gold and silver from the New World facilitated the transfer and accumulation of capital, laying the groundwork for the Industrial Revolution. With the Industrial Revolution, production became increasingly roundabout and dependent on the use of large amounts of capital. The role of capital in the economies of Western Europe and North America was so crucial that the socio-economic organization prevailing in these areas from the 18th century through the first half of the 20th century became known as the capitalist system or capitalism.

In the early stages of the evolution of capitalism, investments in plant and equipment were relatively small, and merchant, or circulating, capital—that is, goods in transit—was the preponderant form of capital. As industry developed, however, industrial, or fixed, capital—for example, capital frozen in mills, factories, railways, and other industrial and transport facilities—became dominant. Late in the 19th and early in the 20th centuries, financial capital in the form of claims to the ownership of capital goods of all sorts became increasingly important. By creating, acquiring, and controlling such claims, financiers and bankers exercised great influence on production and distribution. After the Great Depression of the 1930s, financial control of most capitalist economies was superseded in part by state control. A large segment of the national income of the United States, Great Britain, and various other countries flows through government, which as the public sector exerts a great influence in regulating that flow, thereby determining the amounts and kinds of capital formed.

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