The End of Theory: Financial Crises, the Failure of Economics and the Sweep of Human Interaction By Richard Bookstaber. Princeton University Press; 240 pages; $29.95 and £24.95.

AS QUEEN ELIZABETH II famously once pointed out, most economists failed to predict the crisis of 2007-08. In a lecture to the American Economic Association in 2003, Robert Lucas argued that macroeconomics had succeeded in so far as the “central problem of depression prevention has been solved, for all practical purposes”. Yet within five years the world faced its worst crisis since the 1930s.

In his new book, “The End of Theory”, Richard Bookstaber approaches the issue from a different direction, as someone who has managed risk at leading investment banks and hedge funds. He believes that “traditional economic theory, bound by its own methods and structure, is not up to the task” of predicting crises.

The author argues that the economy is subject to four important phenomena that make traditional economic models useless. The first are “emergent phenomena”. The sum of human interactions can produce unexpected results that are not related to the intentions of the indivuals involved, just as traffic on a motorway can bunch, or crowds can suddenly stampede. The second phenomenon is “non-ergodicity”. An ergodic process follows the same rule every time. If you roll traditional dice, the odds of getting a three will always be one in six. But in the world of human interactions, probabilities constantly change. A linked phenomenon is known as “radical uncertainty”; people do not know the range, or the probability, of future outcomes. The fourth is “computational irreducibility”; the future is so complex, and the effect of human interactions so unfathomable, that people cannot possibly create models to anticipate the outcome.

Mr Bookstaber is also keen on the concept developed by George Soros, a hedge- fund manager, of “reflexivity”—the idea that observations and beliefs about the state of the economy change behaviour, and those changes in behaviour affect the economy. For example, a belief that house prices will always go up makes buyers willing to pay high prices for homes, and banks more willing to lend; the resulting enthusiasm among debtors and creditors duly pushes house prices higher.

What people must do, Mr Bookstaber argues, is embrace the complexity and understand the way the system operates. There are several different types of agents in the financial system, each with their own motivations; some of these (banks in particular) play multiple roles. The way each agent behaves in any given situation may differ depending on the liquidity in the market, and the extent to which it is using borrowed money to finance its activities. The crisis of 2007-08 was the result of indebted institutions operating in an illiquid market.

Watching what markets do in normal times is thus of little help in understanding how they will operate in a crisis. As the author writes: “Measuring relatively small transactions does not give us much insight, just as watching snowshoe hares scurry across a frozen lake gives no indication of whether the ice will support a man.” He takes readers through a step-by-step explanation of the crisis of 2007-08, showing the gradual infection of the system as the different agents followed their own goals.

The analysis is top-notch, and anyone who wants to understand the workings of the financial system will benefit from reading this book. But those looking for a quick fix will be disappointed. Mr Bookstaber says there is no specific model to deal with crises. Instead, he is describing a process—an intellectual approach to understanding the system.

Furthermore, although the author gives a kicking to mainstream economics in general, his analysis focuses entirely on the financial sector. The problems that bedevil economists (inflation, unemployment, productivity) do not feature. The challenge facing traditional economists is to incorporate Mr Bookstaber’s insights into their forecasts. A daunting task.