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Appropriately designed capital markets are important in sustaining reforms in developing • countries, and in the newly emerging democracies of Eastern Europe. Understanding capital markets involves understanding the links and distinctions between the two functions in which capital markets engage: intertemporal trade and risk spreading. Capital markets are different from ordinary markets, which involve the contemporaneous trade of commodities, since in capital markets money today is exchanged for a (often vague) promise of money in • the future. This distinction plays an important role in explaining why capital markets cannot be, and are not run as, conventional auction markets, and why as a result there may be credit (and equity) rationing. The economic theory of financial markets is applied to five problems particular to the transition of the emerging democracies of Eastern Europe: (i) the establishment of a "hard" budget constraint in financial institutions, (ii) the creation of new institutions, (iii) the problem of inherited loan portfolios, (iv) the introduction of • competition in the financial sector, and (v) the relationship between finance and corporate control.


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