Recession Red Light?

Adam Hamilton    February 16, 2001    3740 Words


For all of history, humans have loved to build things.  Some of our creations are extravagant, such as the great Taj Mahal of India, one of the most exquisite palaces ever built, and some represent pure engineering brute force, like the rapidly growing mammoth Three Gorges Dam in China.  Some human building creations weather the harsh tests of time well, and others succumb to the inevitable victory of entropy.  Of every incredible thing humanity has collectively constructed so far, the Seven Wonders of the Ancient World stand near the top of the list in raw engineering prowess, romance, and outright beauty and elegance.


Scattered around what we call the eastern Mediterranean and Middle East today, the Seven Wonders rightfully inspired vast awe and pride in the times of antiquity.  These fabled Seven Wonders were the pyramids of Egypt, the Hanging Gardens of Babylon, the statue of Zeus at Olympus, the Mausoleum at Halicarnassus, the Temple of Artemis (Diana) at Ephesus, the Colossus of Rhodes, and the Pharos (lighthouse) of Alexandria.


Unfortunately, the only ancient Wonder surviving today is the mighty man-made mountains of the Great Pyramid and its pair of companions gracing Egypt’s Giza plateau.  As well as being the only surviving Wonder, they are also the oldest.  The Pyramids are endlessly fascinating, and the more scientists study them the more amazing they seem.  The mathematical precision that went into engineering and constructing these monoliths would be difficult to duplicate today even with modern state-of-the-art laser-guided construction techniques.  The Pyramids still inspire awe and wonder after over four and a half millennia, and we can look at these magnificent buildings and gain a sense of the marvel that the ancients must have felt when viewing ALL seven of their Wonders.


The second Wonder, the Hanging Gardens of Babylon, was a mountainlike series of heavily planted terraces that dwarfed the Babylonian skyline.  Babylon, today sixty miles south of Baghdad, Iraq, was one of the mightiest empires of antiquity.  King Nebuchadnezzar, the same king that sacked the original Jewish Temple in Jerusalem around 600 BC, another amazing construction, commissioned the Hanging Gardens for his favorite wife, who was homesick for her lush green homeland while observing the barren desert surrounding Babylon.  For travelers approaching the mighty city, the Hanging Gardens where said to look like a magical jungle mountain in the middle of a foreboding desert.  Engineers today are still unsure of how the waters of the mighty Euphrates River, which bisected Babylon, were pumped up into the verdant green terraces.


The massive statue of Zeus, the chief God in Greek mythology, at Olympia was the third Wonder.  Over 40 feet tall, the Greek sculptor Phidias’s opus magnum awed pilgrims for almost 1000 years.  It was so BIG that visitors often spent more time discussing the ornate throne Zeus sat on, which was much easier to inspect than the body and head of the statue high in the air.  If the statue would have stood up, it would have ripped the roof off the Temple of Zeus.  It was the central feature of the temple, and no doubt the most impressive work of Greek sculpture in history.


The fourth Wonder, the Mausoleum of Halicarnassus, is perhaps the most curious of all seven of the Wonders.  It was named after a vain King, Mausolus, of the kingdom of Caria in what is today the southwest coast of Turkey.  He was obsessed with death and he commissioned a vast army of the best sculptors and engineers available to build a monstrous rectangular tomb.  The Mausoleum was huge, sporting an Ionic colonnade that supported a pyramid on the roof.  Its total height was over 140 feet, equivalent to a 14 story building today.  The outer surface of the tomb was literally covered with large exquisite statues.  At the apex the largest statues were a four horse chariot team pulling King Mausolus and his lovely wife Artemisia.  Today the generic word “mausoleum” applies to any magnificent tomb.


The fifth Wonder was the Temple of Artemis in the city of Ephesus (also in western Turkey today).  It was a mammoth temple surrounded by hundreds of massive columns, 60 feet high and over six feet wide at their base.  It took 120 years to complete.  Although mostly rock and fine metals, it had extensive wooden fittings.  On July 21, 356 BC, the very night the famous Greek conqueror Alexander the Great was born, a madman named Herostratus set the Temple afire, and in his trial he said he wanted his name remembered forever.  Mission accomplished!  Rebuilt after the arson attempt, the Temple of Artemis was ultimately destroyed by the Goths in 262 AD.


The sixth Wonder graced the harbor at the Greek island of Rhodes.  The Colossus was a huge 105 foot tall bronze statue of the Greek sun god Helios, erected to guard the harbor of Rhodes.  Legends say the statue straddled the entrance to the harbor, but modern engineers believe the statue would not have been structurally strong enough to stand with its legs spread apart.  It may have stood off to the side of the entrance in reality.  Nevertheless, the bronze giant guarding the harbor looked like a sun god when the bright sunlight reflected off the polished metal, and inspired great awe.  Only six decades after it was built, an earthquake destroyed it in 224 BC.  The huge pieces lying on the ground were still regarded with wonder for nearly a thousand years.  In 656 AD a metal dealer bought the pieces for scrap metal, and melted them down, ending the tale of this Wonder.


The seventh Wonder, and perhaps the most magnificent of all, was the Pharos (lighthouse) of Alexandria.  Located on an island in the harbor of Alexandria, Egypt, the Pharos stood a phenomenal 440 feet tall, comparable to a 44 story skyscraper today!  The great lighthouse was made of exquisite white marble, and for more than 1000 years safely guided Mediterranean trading vessels to safe harbor in Alexandria.  Built in 280 BC by Ptolemy II, the lighthouse was severely damaged by an earthquake in 955 AD, and had crumbled completely by 1500 AD.  It must have been an incredible structure to survive for over a millennium in the strong winter storms that ravish that part of the Mediterranean Sea.


One of the great puzzles of antiquity is how the light in the lighthouse was kept shining.  Some historical accounts claim a huge fire was kept burning at the top, 24x7x365.  No one is certain what the fire burned or how the logistics of feeding the voracious beast were accomplished.  Alexandria is certainly not in the middle of a forest, so if wood was the fuel where did it come from?  If some petroleum product was used, how did the ancient Egyptians transport and store it, and feed it into the fire without blowing up the top of the Pharos like a Roman candle?  How did the Egyptians protect the rock superstructure from the intense heat of a perpetual fire?


Some reports allege that the Egyptians developed a brilliant system of glass lenses and bronze mirrors to focus the light thrown off by the great fire out to sea.  Some scholars also report that these mirrors where used to reflect sunlight during the day instead of stoking the fire, which would solve part of the heat dissipation problem.


At night, however, the fire always burned intensely.  The fire was typically orange, and lent an orange cast to the light beamed out of the Pharos.  When sandstorms bludgeoned the Egyptian coast and blew sand far north into the Mediterranean, lookouts manning the extensive merchant fleets would see a blood red light from the Pharos, the pervasive sand filtering out the other visible light wavelengths.  The bright red light reminded the ancient mariners of the dangerous waters ahead and assured they were on maximum alert to safely guide their vessels into the harbor of Alexandria, carefully avoiding the unforgiving shoreline hazards.


And what on earth does this have to do with a recession, you wonder?  Fast forward one thousand years…


Today, even Alan Greenspan can sit before Congress and claim he has no idea how to know if we are in a recession until after the fact, and investors should be on maximum alert.  Deciding we are in a recession in a post-mortem autopsy will do nothing to protect capital lost on the rocky shores of the turbulent markets.  Like the great Pharos of Alexandria, many financial lighthouses of the modern world are beginning to glow with blood red warning lights.


Michael Bolser has recently completed some excellent research that may have ferreted out yet another indicator of an impending recession.  In this essay Mr. Bolser granted us the privilege of presenting his results of this intriguing new look at the M3 money growth rate, the federal funds interest rate, and the ECRI Coincident Index.  We will embark on our journey by briefly introducing the data series analyzed…


M3, of course, is simply the broad measure of the money supply in the United States.  We discussed it last week in our essay “Exploding Inflation”.  Lately, M3 has been expanding like a terminal supernova.  This phenomenal growth has led many analysts to conclude the Fed is in panic mode, sensing far more ominous rocky shoals ahead than it has publicly predicted so far.  M3 is also among the best proxies for true inflation in an economy from an Austrian school of economics perspective.


The federal funds interest rate is the interest rate banks charge other banks for the use of federal funds, which are monies deposited at Federal Reserve banks by member commercial banks.  Lately, from watching bubblevision, one rapidly gets the impression that the only thing that matters for the stock market anymore are short-term interest rates.  After all, who needs the antiquated and overrated concepts of earnings, cashflow, and dividends?  (dripping with sarcasm)  For a look at how effective interest rate cuts were in halting the implosion of past bubbles, please check out our earlier essay “Bubbling Interest Rates”.


The ECRI Coincident Index is constructed by the Economic Cycle Research Institute.  Per the ECRI (, the ECRI US Coincident Index (USCI) is designed to track the current state of the US economy.  It is a comprehensive summary measure of the US economic conditions made up of indicators of the US economy including measures of production, employment, income, sales, and mortgage lending activity.  Cyclical turning points in the USCI generally match the peaks and troughs in the US business cycle.


Mr. Bolser chose to use the ECRI index instead of Gross Domestic Product to represent US economic conditions for a couple important reasons.  First, the GDP contains controversial accounting adjustments and arcane hedonics wizardry like the now virtually worthless Consumer Price Index.  Also, there is a huge political incentive for the US government to exaggerate the final GDP growth value.  Since the officially reported GDP numbers have unfortunately grown more suspect in recent years, Mr. Bolser wanted to use an independent measure of US economic activity.


Like the legendary blood red light of the Pharos of Alexandria, he believes that these three variables may interact to create a red warning light for US investors about impending recessions.  Being vigilant for recessions is just as important for investors as being vigilant for rocky shoals was for the ancient mariners.  The strategies to build and preserve capital through negative economic growth, recessions, can be VERY different from tactical capital deployments in normal growth periods.


Before we leap into the fray, an important caveat is in order.  The complexity of the US economy makes the space shuttle look like a paper airplane, so there are large risks involved in drawing macro-economic conclusions from simple data sets.  These charts and this hypothesis should be viewed with caution and in light of other economic information becoming available, not in a vacuum.


The first graph shows over 40 years of M3, fed funds rate, and ECRI Coincident Index (henceforth just “ECRI”) data.  The red line represents the M3 growth rate, the sky blue line the fed funds interest rate, and the dark blue line the ECRI.  In this first graph, focus on the dashed zero line and the ECRI dark blue line.  In the last 40 years, there have been five major recessions, each marked by negative economic growth.  The first one around 1960 is not labeled, because this dataset does not extend far enough back to make a leading prediction on this early recession.  The remainders, on which we want to focus, are tagged with letters A-D.  Recession C in the early 1980s is considered as a single recession, because the brief “recovery” in the middle was nothing more than a head fake to lure optimistic cheerleader economists to their doom…



As is evident from the graph, recessions are more or less cyclical, but most of the time in the last four decades the US economy has been growing.  Notice that the red M3 growth line exceeded the light blue line, fed funds rate, by large amounts prior to the lion’s share of recessions of the last 40 years.


Mr. Bolser’s thesis is that when the M3 growth rate EXCEEDS the fed funds rate by a large margin for an extended period of time, recessions usually follow.  If this thesis can be validated through further study, then we may be able to weave a more complete tapestry surrounding the future impact of today’s anomalously high M3 growth.


When fiat money is created out of thin air at ever increasing rates, and the Fed slams down interest rates at the same time, the gap between M3 and fed funds grows dramatically.  Taken together, these may be a valid signal from the Command and Control economic gurus at the Fed that all is not hunky dory in the economy and trouble brews on the horizon.


In the graph above, there are four very distinct periods (marked with numbers 1-4) when M3 growth far exceeds the fed funds rate.  The Federal Reserve in these cases was rapidly creating fiat currency with both hands, and at the same time the price of money as measured by the fed funds rate was much lower than the new money growth rate.  Note that periods 1, 2, and 3 in the graph of the M3 exceeding the fed funds ALWAYS heralded recessions, marked A, B, and C.


Mr. Bolser calls these periods of time of M3 far outstripping the fed funds rate “inversions”.


The next graph makes fed funds inversions much clearer and easier to digest.  The same dataset graphed above is employed, but the fed funds rate is SUBTRACTED from the M3 growth rate.  The ECRI is graphed in dimmed light gray below (slaved to the left Y-axis), and the M3 growth less the fed funds rate is dressed in maroon (calling the right Y-axis home).  As you study the graph, note the periods of time when the difference between M3 and the fed funds rate was positive, when the maroon line EXCEEDS the dashed zero baseline…



In the periods marked by numbers 1, 2, 3, and 4, the area of the fed funds inversion was massively positive.  In the 1960s, this inversion lasted a very long time, but a recession did ultimately follow this proposed leading indicator.  Periods 2 and 3 are even more interesting, however, as they show huge increases in the fed funds inversion right before the two sharpest recessions of the last 40 years, marked by B and C.  In addition, the magnitude of each inversion (the total area above the zero line) appears to be positively correlated with the severity of the recession.


It is also apparent that the severity of recessions A and D is not as great as B and C.  Recession A was near the end of the Vietnam War, and recession D followed the Gulf War.  It is possible that the massive additional government spending in time of war aided the economy, partially lessening the impact of the economic imbalances that lead to a recession.  Recession D is also interesting because there was no excessive fed funds inversion that preceded it.  It is obviously a different breed of recession, not one spawned by excessive Fed M3 growth…  This is an important object lesson, as excessive M3 growth is NOT the only way of plunging the economy into a recession!


Please scroll back up to the first graph and notice the bright red M3 line declined dramatically into the early 1990s.  In that wonderful yet discouragingly brief period of time, M3 growth was actually disciplined.  Why did this happen?  Who knows…  The Federal Reserve folks may have been on vacation, or they may have read some of Dr. Ludwig von Mises’ books and seen the folly of inflationary policies, or they may have witnessed the fall of the Soviet Union and realized that the quantity and the price of money are best set by the FREE MARKETS and not by a Command and Control group of elite private bankers in a smoke-filled room.  For whatever reason, this illusion of responsible monetary restraint soon vanished and the Fed jumped right back into its inflationary policies of the last 40 years.


With the benefit of recent economic history and Mr. Bolser’s fed funds inversions, is the Recession Red Light now shining like the venerable Pharos of Alexandria?


Period 4 in the graph above, the present, is very provocative.  M3 growth currently exceeds the fed funds rate by a large margin, and this is likely to grow further as the fellows at the Fed try to delicately stop the roaring locomotive of the Kondratieff speculative bubble implosion.  The last two times a fed funds inversion of this magnitude happened, the US economy was plunged into severe recessions.  As is obvious in the graph, it has been 23 years or so since the last fed funds inversion of this magnitude, and an ugly recession followed hot on its heels.

This, of course, does not conclusively prove we are heading into a recession like the early 1980s, but the risks are certainly high and the graphs do seem to indicate that a similar recession may be knocking at the door.  In another ominous echo through history, today’s fed funds inversion began in a good economy just like the excellent economic backdrop of 1977 to 1978 (notice the ECRI boom during that time in the graphs above).  For the folks today expecting an almost trivial early 1990s style recession, this will be a real wakeup call if we move into a period of time similar to the early 1980s.  The prolonged access to easy money shown in these M3/fed funds inversion periods may have led to a massive high technology production over-capacity as well as masking structural weakness in business.


Marshall Auerback in his outstanding recent PrudentBear essay, “The Fed Starts to Use Up Its Bullets…” (, found similar results when he compared GDP with today’s excessive capital expenditures…  “But the capital expenditure excesses now apparent in high tech in particular are coming increasingly to resemble a classic end-of-cycle investment blow-off, common to many economies at the end of a long boom…”


One final graph is in order, which is a blow-up of the last eleven years of the previous graph…



In past federal funds inversions, the Federal Reserve tended to turn off the monetary spigots as the economy nosed over and turned south.  This is readily apparent by studying the red M3 line way above in the first graph of this essay (note the behavior of the M3 growth rate during fed funds inversions 1, 2, and 3).  This time, however, as is evident in the small blow-up graph above, the Federal Reserve has so far been INCREASING the M3 money supply growth rate as the ECRI has commenced a sharp dive and is rapidly approaching the hard and unforgiving ground at the zero line.


Like the riddles and obfuscation that seems to be the only public language the Fed officials speak these days, we have to wonder why they are pursuing the most inflationary policy since the 1980s as a potential recession looms.  In his Capitol Hill report last week, the Chairman no longer boasted of no inflation, indeed, he remarked that rising energy costs have had a negative effect.  January PPI prices rocketed ahead by a gut-wrenching 13.2% annualized rate, the largest month over month increase since 1990!  This situation yields a significant probability we will see a period of stagflation, where monetary inflation reigns supreme during a recessionary period of negative growth. 


Watching the Fed lately is like watching a gerbil on speed!  So much for the “gradualist” and coherent approach that Alan Greenspan has long championed!  In 2001 so far the Fed’s action on M3 and interest rates has been almost unprecedented in history and certainly points to naked, unbridled panic in the smoke-filled room of the elite private bankers.  The Fed acts as if THEY are losing confidence!


In light of the current M3/fed funds inversion and the historical data showing the consequences of this kind of action in the past, we believe there is an ever-increasing probability that the US economy is already plunging into a recession.  The fed funds inversion will no doubt further exacerbate any coming recession, causing its magnitude to far exceed the 1991 economic downturn.


When ancient mariners sailing the beautiful yet deadly waters of the eastern Mediterranean saw the magnificent blood red light of the mighty Pharos of Alexandria, they immediately knew that they better be on maximum alert because the dangerous rocky shoals and sandbars of the north coast of Egypt were rapidly approaching.  Captains of vessels who did not heed the warning of the lighthouse often saw their ships destroyed, and their wealth lost and buried forever in the shifting sands and mud at the bottom of the Mediterranean.


Mr. Bolser’s latest intriguing research, added to the wealth of already existing information about the dubious state of the US economy, is yet another Recession Red Light burning its bright warning on the horizon.  Investors who want to survive open-sea economic turbulence and make the smooth waters of Alexandrian ports unscathed would do well to post additional lookouts on their merchant ships, being extra vigilant that their capital and investments remain protected in the potentially dangerous waters.  One further Recession Red Light is burning brilliantly in the dark American skies…


Adam Hamilton, CPA     February 16, 2001     Subscribe