The U.S. government should take stakes in banks in order to recapitalize them rather than instituting a $700 billion bailout package, as the economy is one step away from depression, Hugh Hendry, chief investment officer and Partner at Eclectica Fund, told CNBC on Thursday.
"The issue with the banking sector is not one of liquidity. They are drowning in liquidity. They're bust because they are leveraged," Hendry told "Squawk Box Europe."
He said the U.S. government should follow the example of legendary investor Warren Buffett and of sovereign wealth funds and buy stakes of between 30 percent and 50 percent in banks.
(Watch Hugh Hendry on CNBC to the left).
"The private sector doesn't want to bet on another bad horse. It calls for the government to act as a lender of last resort," Hendry said. "The leverage would immediately collapse. You'd have recession, but you'd have a chance of averting depression."
The government's bailout plan is unpopular because it is asking taxpayers to pay more than the market value for bad assets, and they are outraged, he said.
"This deal, bring it on, because it's better than nothing, but not much better than nothing," Hendry said. "We're a heartbeat away from depression."
The root of the problem lies in the abolition of the Glass-Steagall act, which was introduced in 1933 and separated investment banks from commercial banks to prevent Wall Street financial speculation affecting the broader economy.
"It worked, and it worked, and it worked… except it was repealed 10 years ago," Hendry said. "It's not legislation, it's the legislators, that's what you have to worry about. This is the same Congress that repealed the act, this is the same Congress that let the genie out of the bottle, I ain't seeking salvation from these guys."
A depression could be averted is the Federal Reserve could persuade banks to stop hoarding cash and start lending to each other, he said, adding that central banks should lend money only on the condition the commercial banks don't hoard it.