Bailout

What is the connection between removing water from a sinking vessel using a bucket, paying for someone’s release from jail, and jumping from an airplane with a parachute? Yes, all these activities are referred to by the verb “to bail out”.

All these meanings have one more common thing. They imply a rescue from some trouble or difficulty. Similarly, in finance or economics, bailout means providing money to a person, a company, or a country that is in financial distress. In other words, bailout is the injection of money into a business or organization that would otherwise face imminent collapse. Bailouts are typically reserved only for systemically-important institutions or companies that are considered too big too fail. Although in theory anyone can provide a financial help, governments typically engage in bailouts to ease the financial crisis.

The best known example of government bailouts is perhaps the Troubled Asset Relief Program (TARP), which injected more than $400 billion to American automakers and financial institutions, including the AIG, marking the biggest bailout in financial history. Another famous case is the €110bn bailout of Greece in 2010 by the European Commission, European Central Bank and International Monetary Fund.

Bailout and Gold

What is the link between bailout and gold? Theoretically, on the one hand, government bailouts signal a grave situation, which could increase the safe-haven demand for gold. They can also boost the public debt, raising concerns about the sovereign debt crisis in the future. On the other hand, the government bailout may ease the crisis and prevent it from cascading, thus calming the financial markets, hurting gold.

So much for theory. Let’s take the chart below, which shows the gold prices around the TARP. The bailout was announced on October 3, 2008, shortly after the collapse of the Lehman Brothers. As one can see, the price of gold initially jumped from $828 to $903,5 five days later.

^{Chart 1: Gold prices (London P.M. Fix, $) around TARP}

However, after this initial positive reaction, the gold prices plunged to $712,5 at the end of October, when it started to rally again. It shows that bailouts can calm financial markets for a while, putting gold under pressure. However, they are rather ineffective in permanently blocking an underlying upward trend.