The Wearing

The workshop opens with the same machines it had a year ago. The accounts show sales; the owner has taken an income; the floor looks much as it did. Yet part of what made those sales possible has been used up. Bearings have worn, useful lives have shortened, and equipment that still works faces newer equipment that does the work more cheaply. To keep the enterprise capable of furnishing the same services requires an expenditure that can be mistaken for expansion because new things arrive through the door. This is depreciation, the wearing-away that stands opposite investment in the account of a capital stock. Gross investment records the additions; depreciation recognizes the consumption of the assets already there. The distinction changes the meaning of prosperity. A business, or an economy, can build a great deal while adding little to what it holds, because much of the building makes good the capacity and value consumed in producing its income.

The word “wearing” makes the process sound entirely mechanical, but the economic measure concerns value. The OECD's capital manual defines depreciation through the loss in an asset's value as it ages, holding the price basis comparable. Ordinary deterioration, normal obsolescence, and the accidental damage ordinarily expected in production belong in consumption of fixed capital. The wealth measure and the service measure can therefore move differently. Imagine a machine expected to deliver ten units of net receipts at each year's end for ten years, with no resale value, no uncertainty, and a zero discount rate. It begins worth one hundred. After the first receipt, it has nine payments left and is worth ninety, even if its ability to produce the next year's output is unchanged. One year's future service has become one year's past service. The machine can retain its current productive efficiency while its remaining value falls. This is why an account of what equipment can do now and an account of what its owner still possesses need different measures of the same equipment.¹

Gross and net investment put this loss into the stock account. Suppose a homogeneous stock starts the year at one thousand, gross investment adds one hundred and twenty, and depreciation consumes one hundred, all measured on a common price basis. With no other changes, the year closes at one thousand and twenty. The economy has produced one hundred and twenty of investment goods but added twenty to its net capital stock. If investment had been eighty, the stock would have fallen to nine hundred and eighty despite the positive investment flow. Replacement production is real production: people work, materials are used, and goods are delivered. Its inclusion in gross output tells us how much activity occurred. Subtracting capital consumption answers a further question about how much remains after using up part of the productive estate. And a rise in asset prices must be recorded separately. If the same closing assets gain fifty in value through revaluation, the money value of wealth rises by seventy in the first example, while the investment-minus-depreciation contribution remains twenty.²

Keeping a stock in service also involves maintenance, whose place in the account depends on what the work accomplishes. Routine servicing is an expense of continuing production; a substantial improvement that extends an asset's life or increases its productive capacity may be capital formation. The boundary requires judgment. Painting a wall, rebuilding a roof, and adding another floor all employ labor and materials, but they do different things to the remaining asset. Nor is a depreciation allowance itself a repair. Recording a cost recognizes consumption of capital; it neither purchases a replacement nor reserves cash unless the owner takes a further action. A business may report the allowance while distributing the money that could have financed renewal. Conversely, careful maintenance can extend a machine's useful life and change the depreciation path that was expected when it was bought. The account has to follow the service life and value that the work actually sustains, rather than treating every expenditure on an old asset as new capacity or every accounting charge as a physical act of preservation.³

The expected character of the loss matters as well. A machine may be scheduled to lose value as a newer generation gradually makes it less useful; the anticipated shortening of its economic life belongs in the ordinary reckoning. A sudden technological surprise that forces premature scrapping, or an exceptional catastrophe that destroys a factory, requires another entry. In the national-accounting framework used by the OECD manual, these exceptional losses are other changes in asset volume, while movements in the prices of otherwise comparable assets are revaluations. All can reduce wealth. Keeping them separate tells us whether the year used capital in the expected course of production, suffered an exceptional loss, or repriced what survived. It also restrains the comfort of a simple percentage. Buildings, vehicles, and software have different service lives; use and maintenance vary; used-asset markets may offer incomplete evidence. A smooth depreciation rate is an assumption or estimate about this heterogeneous process. It is useful precisely to the extent that the changing assets have been made comparable and the loss being measured has been named.⁴

The amount required merely to stand still depends, finally, on what is being held still. In a simple model, let a uniform capital stock of one thousand lose ten percent each year. Investment of one hundred restores the total to one thousand. If the workforce meanwhile grows from one hundred people to one hundred and ten, capital per worker falls from ten to about nine point one. Preserving ten per worker requires a closing stock of eleven hundred, so investment must be two hundred: one hundred to replace depreciation and another hundred to equip the additional workers. A constant aggregate stock and a constant stock per worker are different resting points. Technical change introduces a further standard, capital per unit of effective labor, if the model treats workers' productive effectiveness as growing. This is the care needed when the language of a steady state enters the account. The relevant level or ratio can remain constant while investment continues and the aggregate economy grows. The reservoir may have to expand simply to give every new arrival the same share of water.⁵

A fortune therefore has to be understood through the things and claims that compose it. The roof, vehicle, and machine call for renewal; a financial claim has contractual payments, valuation changes, and risks that need their own account. Applying one physical decay rate to all wealth would conceal the differences the balance sheet is meant to reveal. But the central discipline carries across them: distinguish the flow the asset furnishes from the portion of that flow that consumes, preserves, or enlarges the remaining holding. The owner who spends the gross receipt may be eating into capital; the society that celebrates every new building may overlook the buildings it is replacing. Growth begins beyond the amount needed for the chosen standard of preservation, and that standard must be stated. The next plate turns from the wearing of assets to their valuation: how a holding is priced, and how its expected services become a fortune in the present.