Alan Greenspan has spent the last five years revising his view of the way human emotions influence markets.

The former head of the U.S. Federal Reserve, a famous free-market defender who presided over the Fed from 1987 to 2006, is now questioning many of the assumptions that guided his term as chair of the world’s most powerful central bank.

In a 2010 hearing before the U.S. Congress, Greenspan admitted there was a “flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.”

Greenspan said his free-market view of how markets and economies work had seemed to apply well for more than 40 years, but admitted the 2008 crisis, which saw the U.S. housing bubble burst and banks around the world failing was not something he could have predicted.

In the years since, he’s become a convert to at least one form of regulation – adequate capital for banks.

And in his new book The Map and the Territory: Risk, Human Nature and the Future of Forecasting, he tries to work out a new economic theory that would encompass the kind of meltdown that happened in 2008.

In an interview with CBC’s The Current, he says his new book is a “detective story” with step-by-step analysis applying different market theories to real world events. But it’s also a narrative, telling his own thinking throughout his term as Fed chairman.

'If you had significant capital in the American financial system at the time of the crisis, it wouldn’t have mattered what kind of assets were being held by the bank, so long as they didn’t go into default'- former Fed chairman Alan Greenspan

Greenspan admits his view of the world was flawed.

“It was a rather fundamental flaw. I and a very substantial majority of economists – not that we didn’t believe people behaved irrationally a good deal of the time – but our general presumption over the long run was it is long-term self-interest which governs decisions and the irrationality, the emotion and a variety of emotions that would interfere with that essentially is random, can be essentially disregarded."

He’s adopted an idea from seminal 20th century economist John Maynard Keynes – the concept of “animal spirits” to explain how human emotions move markets.

"The notion that they are random is mistaken because they have a very significant impact on how markets work and how economies work," he said, giving the example of the “herd spirit” which sees investors follow one another into untested investments.  

“It’s a fundamental flaw in the structure and the last five years I have been trying to integrate my new view of the world, based on integrating animal spirits into the way in which economies behave and the way human beings behave,” Greenspan added.

Greenspan takes no responsibility for the rush to deregulate that prevailed during his term of office, saying the impetus came from politicians rather than the central bank.

Call for adequate bank capital

However, he says adequate capital in the U.S. banking system would averted much of the 2008 crisis.

“If you had significant capital in the American financial system at the time of the crisis, it wouldn’t have mattered what kind of assets were being held by the bank, so long as they didn’t go into default,” Greenspan said.

He argues it’s impossible for economists to predict what will be the next tech bubble or housing bubble or other crisis.

He says adequately capitalized banks would be able to ride out the turmoil – with the pain shared mainly by the banks and their shareholders – if they had enough capital. Greenspan is proposing at least 20 per cent capital ratios, twice the 10 per cent now in place.

“It’s hard to tell which assets will be toxic. The best way to ensure that only shareholders and banks feel it is have adequate capital,” he said.