This paper is concerned with the view that capital formation is an important variable in the determination of unemployment and wages in Germany and the UK. Adverse demand shocks affect employment and investment. When shocks reverse, unemployment may not fall to previous levels due to insufficient capital. The empirical results show that unemployment has risen in the last twenty years in both countries due to insufficient investment. Policies that are aimed at stimulating investment may have a permanent effect on unemployment in Germany and the UK. Copyright 2000 by Scottish Economic Society.