The financial crisis of 2008 and the deep recession that followed forced each of us—perhaps most notably, Alan Greenspan —to question the fundamental assumptions about risk management and economic forecasting. Mr. Greenspan, the nation’s chief forecaster as chairman of the Federal Reserve Board, steered the nation through almost two decades of prosperity and relative stability, retiring from the Fed in 2006 with an unparalleled reputation for prescience. And then came the economic crisis, and no one’s reputation for prescience survived.

In prepared remarks before a congressional hearing a month after Lehman’s September 2008 bankruptcy, Mr. Greenspan declared: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief.” He was hardly alone in failing to predict the economic tsunami. Equally clueless were government officials, Wall Street practitioners and professional economists. In “The Map and the Territory,” Mr. Greenspan tries to explain what went wrong and offers suggestions for how we can do a better job.

The author argues that traditional forecasting methods failed because they paid too little attention to the work of behavioral economists. Forecasting can be improved, he says, if specific behavioral conditions and tendencies—such as euphoria, fear, panic, optimism and herding—can be incorporated into forecasting models, including the irrational ways in which people behave during times of stress. Effective models of the economy shouldn’t assume that most people exhibit completely rational behavior and that outcomes are contained within predictable bell-shaped (“normal”) distributions.

With such adjustments in place, models will inevitably show that outcomes in financial markets will be far more extreme than suggested by normal probability distributions. Moreover, the extremes of the distributions will tend to be asymmetric—extreme negative outcomes are particularly likely: Fear is more potent than euphoria. Ignoring these implications, Mr. Greenspan argues, blinded government policy makers and business practitioners to the full extent of the risks that were revealed during the 2008 crash and the crisis that followed.

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The Map and the Territory

By Alan Greenspan
(Penguin Press, 388 pages, $36)

Mr. Greenspan’s explanation for the 2008 crash differs from some of the politically popular views. It wasn’t “deregulation,” he says, but rather a failure of the existing regulatory system that caused the crisis. In particular, regulators failed to appreciate the extent to which financial institutions had inadequate equity capital. Nor were private mortgage lenders and investment bankers the only villains in the piece. The heaviest demand for securitized mortgage securities came from Fannie Mae and Freddie Mac, the government-sponsored enterprises attempting to meet the nation’s “affordable housing goals.”

Where Mr. Greenspan’s analysis is unexceptional is in his emphasis on leverage (excessive borrowing) and inadequate capital as key elements that made the 2008 crisis so destructive. Both individuals and financial institutions were drastically undercapitalized. With inadequate capital buffers, the losses that surfaced after the Lehman bankruptcy set off an avalanche of defaults.

Bubbles and crashes will always be characteristics of free-market systems, but they need not lead to economic crises. In 1987 the stock market fell over 20% in a single day, but the effect on economic activity was minimal because holders of common stock weren’t highly leveraged. The bursting of the Internet bubble in early 2000 left only a mild imprint on the financial system and the real economy for the same reason. The crash of the housing bubble was devastating because the toxic mortgage-backed assets were held by highly leveraged institutions, and this debt was short-term rather than “permanent” and thus especially susceptible to “runs” where lenders were unwilling to “roll over” their short-term loans. “It was the capital impairment on the balance sheets of financial institutions that provoked the crisis,” Mr. Greenspan writes. In his view, the answer is not more regulation but more capital.

“The Map and the Territory” ranges beyond the market crisis and predictive models. Mr. Greenspan offers a conservative but balanced discussion, for instance, of the need to restrain the growth of entitlement spending. In his section on income inequality he emphasizes the role of globalization and the rise in stock-based compensation, as well as the failure of our education system to produce skills for the workforce that match the needs of the economy. He says that immigration reform, by loosening the requirements for H-1B visas, would allow us to draw on a large pool of skilled workers abroad and thus stabilize income inequality. At the moment, immigration restrictions protect, and thus subsidize, high-income earners from global wage competition.

Five years after the financial crisis, Mr. Greenspan notes, the large institutions that can create systemic risks are even larger than before. Such institutions are “too big to let fail” and have become de facto government-sponsored enterprises. Eventually, their dependence on government protection will shield them, Mr. Greenspan says, from the “creative destruction” that is a hallmark of dynamic capitalism.

Mr. Greenspan is not known for the intelligibility of his utterance. (“Since becoming a central banker,” he once said, “I have learned to mumble with great incoherence.”) It is therefore refreshing to find that “The Map and the Territory” is a model of expositional clarity, with complex and recondite matters made accessible to the lay reader. The book should be must reading for anyone interested in the way our financial markets work—and sometimes fail to do so.

Mr. Malkiel is the author of “A Random Walk Down Wall Street.”