The US economy may plunge into a depression if the $700 billion rescue package fails to revive the ailing banking sector, says Ilian Mihov, INSEAD Professor of Economics.

“The Great Depression (this time) is still unlikely but it is not impossible any more. This is quite sad,” Mihov says.

The Bush administration proposed the bailout plan as US financial institutions continued to wilt under the weight of distressed financial assets. In September alone, the Federal Reserve had to rescue America’s biggest mortgage lenders Freddie Mac and Fannie Mae, as well as insurance giant AIG.

In a sign of deeper problems in the financial sector, Lehman Brothers filed for bankruptcy, Bank of America took over Merrill Lynch, while JPMorgan took over Washington Mutual. The financial sector’s deterioration has accelerated since Bear Stearns was jointly rescued by the Fed and JPMorgan from the brink of collapse in March.

“The bailout package does not solve the problems of the economy but nevertheless it is a necessary thing to do so we can stop the collapse,” says Mihov, who had studied under Fed chairman Ben Bernanke and co-authored several papers with him, including one on the Great Depression.

More banks could fail if distressed financial assets are not taken off their balance sheets because these assets continue to deteriorate every day, creating more uncertainty for the investors and bank depositors. Such a situation could force a fire sale of bank assets to satisfy demands from investors and depositors, further weakening the banks’ balance sheets.

“This is a vicious cycle that could lead to an implosion of the real economy,” Mihov told INSEAD Knowledge.

Once this happens, banks will be unwilling to lend. If companies cannot borrow from the banks, production cut backs will follow, workers will lose jobs, demand in the economy will fall and companies will be unable to pay their debts.

“This was the vicious spiral that was behind the Great Depression,” Mihov says.

But a spiral of the economy into depression can be avoided if the government takes timely and decisive action to rescue the financial sector.

“It (the bailout) has to be done,” Mihov says.

Although the Bush administration had already acknowledged the magnitude of the problem with its rescue plan, the House of Representatives rejected the plan at the end of September. In a second vote in early October, the House approved a revised version.

Democrats have blamed the Bush administration for spawning ineffective policies to deal with the 13-month old crisis and even some conservative Republicans were not convinced the plan would work.

“We have learned the lessons of the Great Depression but the politics can be so different from the economic point of view,” Mihov says.

Political differences, between the outgoing Hoover administration and the incoming Roosevelt administration, stalled efforts to minimise the damage caused by the credit squeeze on the US economy in the 1930s.

Hoover lost the elections in November 1932 and Roosevelt came into power in March 1933. During those five months, Hoover and Roosevelt could not agree on what to do with the banking sector, Mihov says. “That aggravated the situation and a lot of people became unemployed in the period of just five months.”

In the case of today’s financial crisis, politicians are failing to see the bigger picture.

“The politicians do not see the forest from the trees. The important thing is to save the economy from collapsing,” Mihov says. “We may agree or disagree whether the banks’ CEOs are overpaid or whether they should be punished or go to jail. These are important points but these are points that can be dealt with later.”

During the Great Depression, Roosevelt made decisive actions at the beginning of his administration to prevent the further collapse of the economy, but action was taken to regulate the banking sector with the passing of Glass-Steagall Act in June 1933.

The Glass-Steagall Act was a very important piece of legislation that separated investment banking and commercial banking activities. It was repealed in 1999, allowing banks to be both commercial and investment banking entities.

Whether such a regulation is needed to prevent a similar crisis in the future will have to be debated in Congress, Mihov says, but for now the important thing is to save the economy from collapsing.

This article was first published on September 29, 2008

To see Ilian Mihov on CNBC, click here

JB 09/08