ROME — The numbers seem crazy.

Earlier this month, UBS, the sober-minded Swiss banking giant, predicted gold would hit $2,500 (U.S.) an ounce in the next five years. Fresh predictions in the $1,000 to $2,000 range are routine. The hard-core gold bugs, of course, say the sky's the limit as recession-stricken governments print money, devalue their currencies and risk hyperinflation, like Zimbabwe's, where 1,000-dollar notes are so worthless they're used as toilet paper. Gold, they insist, is the only honest currency.

The counterargument is that gold, which has gone from $250 in 2001 to about $925, is already flirting dangerously with bubble status; that once the global economy starts to recover, which could be next week or next decade, investor fear will diminish and money will flow back into equities and other asset classes. Gold, an essentially useless commodity with a pleasing colour, would fade away.

But the bulls have compelling arguments, which does not necessarily mean gold will double or triple in price. It just means up is more likely than down because of the merry confluence of economic and supply and demand factors. Call them bulls lite. The maniac bulls are an entirely different beast. They note that twice in the last century the Dow-gold ratio stood at one-to-one, or close to it, and that we'll see this ratio again fairly soon.

In 1934, the Dow bottomed out at 33 and gold was $35. In 1980, the Dow stood at 800 and gold was $800. In the first instance, the U.S. was getting clobbered by the Great Depression and financial assets were smoking ruins. In the second, the U.S. was on the verge of the deepest recession since the 1930s.

To tame runaway inflation, the Federal Reserve had to slow the money supply growth and jack up interest rates (they eventually reached 21.5 per cent). Again, financial assets were duds and dozens of banks failed.

On Friday, the Dow closed at 7,776.18. To believe in a repeat of the one-to-one ratio, you would have to believe that the Dow - and therefore the world economy - is doomed and that gold is the only asset that will rise above the rubble. In this scenario, the Dow at, say, 2,500 and gold at $2,500 makes perfect sense. Never mind that a stock market that low would indicate the end of civilization as we know it. At least you would have the pleasure of clutching your bullion as you freeze in your cave.

Putting the currency devaluations and fear of inflation aside for a moment, Economics 101 can explain some of gold's ascent.

You've heard of peak oil. How about peak gold? Since 2003, gold production has been falling by about 2 per cent a year (and 4 per cent in 2008) after two decades of production increases. There was a time when 50-million-ounce discoveries were fairly routine. Not any more.

Either the gold in the ground is running out or the current crop of geologists lacks talent. Last year, the gold mining industry discovered 15 million ounces, less than one-fifth of that year's production.

But isn't demand falling too? The recession has indeed crimped the sales of gold jewellery, and diluted the purity of the gold in that jewellery. CPM Group, a commodities research and consulting firm, expects gold jewellery demand to fall from 60.8 million ounces last year to 56.5 million ounces this year. The good news for gold lovers is that the jewellery fall-off is being more than offset by investment demand. In that category, CPM forecasts demand to go from 43.3 million ounces in 2008 to 52.3 million this year.

Which brings us to gold exchange-traded funds, or ETFs. They're on fire.

Four years ago, the ETFs, led by the SPDR Gold Trust, held 200 tonnes of gold. Today, the figure is more than 1,400 tonnes and rising. Some gold investors think ETFs will hold 3,000 tonnes within a decade (Fort Knox holds about 4,200 tonnes). The SPDR fund is a juggernaut. In the first two months of this year, it attracted $7.4-billion from investors, 20 times the inflow in the same period a year earlier. The only bigger ETF is the one that tracks the S&P 500 index fund.

The slump in jewellery demand and the rise of gold ETFs are not unrelated. Simply put, the investors who are using ETFs to diversify their currency risks are willing to pay more for gold than jewellery buyers.

While waning gold production is one factor behind the gold price rise, it pales in comparison to mistrust of the central banks. As the presses print currencies like so many newspaper flyers, confidence in currencies might evaporate, just as confidence in other asset classes - equities, real estate, oil - has evaporated. Investors who were burnt by those assets are now piling into gold.

A quick economic recovery could, theoretically, derail gold's bull run. But it may not. Gold prices did not stop rising when the 1973-1975 recession, which was induced by the first oil shock, came to an end. In fact, prices kept rising until 1980 as the U.S. dollar crumbled.

Contrarian investors must look at gold as a fabulous shorting opportunity. When everyone from hedge funds to retail investors is buying gold to protect themselves from inflation and rotting currencies, surely something has to be wrong. But this time the thundering herd might be right. Gold seems on the verge of adding another digit to its price.

ereguly@globeandmail.com

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