Speculation and the Allocative
Performance of Financial Markets
FINANCIAL MARKETS provide assessments of the relative prospects of companies’ assets. They set prices to reflect the stream of expected future returns on past investments, as well as that of new investment projects for which financing is being sought. Markets allocate capital based on these price signals: the higher the price of a company’s assets, the easier it is for it to attract financial capital, whereas lower prices make financing more difficult. For markets to perform this allocative function well, participants’ decisions to, say, buy and sell shares of particular companies should reflect changes in the relative prospects of companies or projects and the risks associated with investing in them.
As trading decisions in financial markets are based on assessments of future returns and risk, they are inherently speculative. Thus, reliance on financial markets to allocate society’s capital presumes that speculation leads to an allocation that on the whole generates better longer-term returns to investors and society than an alternative arrangement might deliver. The experience of successful capitalist economies, particularly compared to the Soviet experiment in capital allocation without reliance on financial markets, attests to the soundness of this presumption.
However, the success of economies with highly developed financial markets should not be construed as evidence that these markets can somehow fully foresee the longer-term prospects of