This paper examines how financial markets affect the efficiency of capital allocation across 65 countries. It finds that financially developed countries allocate capital more efficiently, increasing investment in growing industries and decreasing investment in declining industries. The efficiency of capital allocation is negatively correlated with state ownership and positively correlated with the amount of firm-specific information in domestic stock returns and the legal protection of minority investors. Strong minority investor rights appear to curb overinvestment in declining industries. The study also identifies three mechanisms through which financial markets improve capital allocation: (1) stock markets that incorporate more firm-specific information into stock prices, (2) reduced state ownership, and (3) strong minority investor rights. The results suggest that financial markets and institutions play a fundamental allocative role in the economy, and that financial market variables explain a substantial portion of the cross-country variation in the quality of capital allocation. The paper complements an emerging literature on the relationship between finance and economic growth, showing that financial development is associated with better capital allocation and economic growth. The study also finds that financial market variables explain a significant portion of the variation in capital allocation quality across countries.This paper examines how financial markets affect the efficiency of capital allocation across 65 countries. It finds that financially developed countries allocate capital more efficiently, increasing investment in growing industries and decreasing investment in declining industries. The efficiency of capital allocation is negatively correlated with state ownership and positively correlated with the amount of firm-specific information in domestic stock returns and the legal protection of minority investors. Strong minority investor rights appear to curb overinvestment in declining industries. The study also identifies three mechanisms through which financial markets improve capital allocation: (1) stock markets that incorporate more firm-specific information into stock prices, (2) reduced state ownership, and (3) strong minority investor rights. The results suggest that financial markets and institutions play a fundamental allocative role in the economy, and that financial market variables explain a substantial portion of the cross-country variation in the quality of capital allocation. The paper complements an emerging literature on the relationship between finance and economic growth, showing that financial development is associated with better capital allocation and economic growth. The study also finds that financial market variables explain a significant portion of the variation in capital allocation quality across countries.