The twin perils of financial crisis and economic recession have caused politicians and regulators alike to tear up the rule book in recent weeks. The result has been a huge public bail-out of the banking sector and a massive fiscal and monetary stimulus. As we look further ahead, however, the crisis has also shown that we cannot ignore the need for a drastic revision in the public understanding of economics itself.

At its deepest level, the crash arose because people and markets did not behave in the way described in economic textbooks. People are not always economically rational. They borrowed too much money to buy houses, then remortgaged to buy other things. Free markets are not always efficient. They mispriced credit as banks hyped 125 per cent mortgages and other debt products to a credulous public, then mispriced it again as the wholesale markets went into gridlock rather than lend against possibly toxic assets. Finally, poorly conceived policy and poorly crafted institutions can fail. There was a huge institutional failure in the regulatory system and in government oversight of the economy.