The second of my essays on the function of banks. In this one, I talk about their relationship with government.

Think of two friends who walk to a neighborhood bar every Saturday night. On a given Saturday, the first friend may be too drunk to walk without assistance, and he may have to lean on the second friend in order to make it home. The following Saturday, it could be the second friend who needs to be supported in order to get home. However, if both of them get too drunk and try to lean on one another to get home, they may collapse together.

This is how I picture the current situation in Europe. Many European banks are unsteady. They need government guarantees and capital injections in order to stay in business. At the same time, many European governments are heavily indebted and running large deficits. They need banks to continue to lend to them in order to fund their spending.

Read the whole thing. My prescription for addressing the relationship between banks and governments is to try to apply the approach of “limited guarantees, for limited purposes.”