* Economy near worst-case scenario, won't recover fast
* Banks should "get back to banking"
* Democrats, Republicans should set aside differences
* Stocks still best bet over the long run
(Adds Buffett comments throughout)
By Jonathan Stempel
NEW YORK (Reuters) - Warren Buffett said Monday the U.S. economy had "fallen off a cliff" but would eventually recover, although a rebound could kindle inflation worse than that experienced in the late 1970s.
Speaking on CNBC television, the 78-year-old billionaire investor also said the economy was mere hours away from collapse last September when credit markets seized up, Lehman Brothers Holdings Inc went bankrupt and insurer American International Group Inc got its first bailout. "The world almost did come to a stop," he said.
Buffett spoke nine days after telling shareholders of his insurance and investment company Berkshire Hathaway Inc that the economy was in a "shambles" likely to persist beyond 2009.
On Monday, he said the country still faces an "economic Pearl Harbor," experiencing a "close to the worst-case" scenario of falling business activity and rising unemployment.
He called on Democrats and Republican policymakers to set aside partisan differences and unite under the leadership of President Barack Obama to restore confidence in the banking system, fix the economy and communicate their efforts better.
"People are confused and scared," he said. "People can't be worried about banks, and a lot of them are."
Buffett said Americans, including himself, did not predict the severity of home price declines, which led to problems with securitizations and other debt whose value depended on home prices continuing to rise, or at least not plummet.
"It was like some kids saying the emperor has no clothes, and then after he says that, he says now that the emperor doesn't have any underwear either," Buffett said.
RECOVERY COULD TRIGGER MORE INFLATION
Berkshire's own stock has fallen by about half since September, with growth in some units such as auto insurer Geico Corp offset by weakness elsewhere, including jewelry retailers that Buffett said have "gotten killed."
He said Berkshire will write less catastrophe insurance this year after investing roughly one-third of its available cash in high-yield securities issued by General Electric Co , Goldman Sachs Group Inc and other companies.
Maintaining his long-term optimism, Buffett said that while the economy "can't turn around on a dime," he believes that "five years from now, I can guarantee you that the machine will be running fine."
He added, "We do have the greatest economic machine that man has ever created."
But he said an economic rebound could trigger higher inflation once demand rebounds. "In economics there is no free lunch," he said. "We are going to attempt to have a lunch that to some extent we're going to pay for later."
BANKS SHOULD "GET BACK TO BANKING"
Buffett called on banks to "get back to banking" and said an overwhelmingly number would "earn their way out" of the recession, even if stockholders don't go along for the ride.
Saying that "a bank that's going to go broke should be allowed to go broke," Buffett nevertheless added that the "paralysis of confidence" in the sector is "silly" because of safeguards such as deposit insurance.
He said Wells Fargo & Co and U.S. Bancorp, two large Berkshire holdings, should appear "better than ever" three years from now, while the ailing Citigroup Inc, which Berkshire does not own, would probably keep shrinking.
Buffett said he still expects Berkshire's derivatives contracts -- whose value depends on where four stock indexes trade a decade and more from now -- to be profitable.
And he defended owning stocks for the long haul, saying that "over a 10-year period, you will do considerably better owning a group of equities" than U.S. Treasuries.
He also defended his imperfectly timed October opinion piece for The New York Times, where he said he was moving non-Berkshire holdings in his personal account to stocks.
"I stand by the article," he said. "I just wish I had written it a few months later." (Reporting by Jonathan Stempel; Additional reporting by Lilla Zuill; Editing by Lisa Von Ahn and John Wallace)