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Why Gold Prices Are Falling Again

Thursday, 15 Dec 2011 | 3:28 PM ET
Gold Bars
AP
Gold Bars

Investors who bought gold as a hedge against the crisis in Europe may be surprised that the price of gold is falling so rapidly. Shouldn’t the prospect of concerted action by central banks to stem a crisis in Europe send gold soaring?

Not really. A bit of history shows that gold falls when governments act to stem a financial crisis.

Take a look at what happened to gold in 2008. Here's the one-year chart for 2008, courtesy of Kitco.

There were a lot of people back then who were caught off-guard. They thought gold was the ultimate hedge against the government “printing money” in reaction to a financial meltdown. But it didn't work like that.

Gold reached its high for the year just as Bear Stearns collapsed and had to be rescued by a deal arranged by the government, which sold the firm to JPMorgan Chase . On March 17, gold ended the day in London at $1,011.25. If you were holding gold as a hedge against financial collapse right then you probably felt pretty good.

Then something funny happened. On March 18, the Federal Reserve cut interest rates 75 basis points. It also created the Primary Dealer Credit Facility, which allowed investment banks to trade highly rated mortgage backed securitiesfor cash.

Obviously, this was the Fed debasing the currency to rescue banks. So gold should soar.

But that’s not what happened. On March 19, gold dropped by almost 5 percent, closing at $958.50. Then the price of gold just kept falling throughout the spring of 2008. When the Fed announced another interest rate cut on April 30, gold fell all the way down to $853.00.

That’s more than a 15 percent decline from the pre-Bear highs.

The summer of 2008 saw gold bounce a bit as the monoline insurers were downgraded and Countrywide was acquired by Bank of America . In June, gold rallied, picking up a lot of steam when the Federal Reserve announced that it was holding rates steady — no more cuts — at the end of June. In short, after the Fed indicated it wasn’t going to keep pushing interest rates down, the gold prices went up.

But the rally was short-lived. After the 2000 Indymac collapse and the government bailed out Fannie Mae and Freddie Mac, gold started falling again. It hit it a new low for the year of $740 on the Thursday before Lehman Brothers filed for bankruptcy.

Gold mounted a rally in September and early October. But it got crushed after the banks were rescued with TARP funds on Oct. 14.

In short, everyone who bet that government bailouts and falling interest rates would “debase” the currency and send the price of gold soaring lost a lot of money in 2008. The price of gold tended to rally when the government took no action and drop when the government acted.

Libertarian gold bugs who imagined the yellow metal was a hedge against government action were just wrong.

So now that we have Europe contemplating a new treaty to address its debt crisis, we shouldn't be surprised that gold prices are reacting this way. Gold falls when governments act in a financial crisis.

Questions? Comments? Email us atNetNet@cnbc.com

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