What's interesting here is the Federal Reserve was already 19 years old at the time and already experienced a few booms and busts and the roaring twenties before this deflationary collapse. So they obviously didn't have their eye on the ball. Look at the chart of the Dow in the 1920s, a rebalancing was inevitable (Michael Pettis, an expert on China, called the U.S. Great Depression a "chaotic rebalancing"). The Austrian school believes it was the monetary inflation and monetary tightening by the Federal Reserve that fueled the massive boom and bust. And to this day, economists wonder if it was the lack of monetary stimulus by the Federal Reserve (money supply, QE) or lack of fiscal stimulus (deficit spending) that failed to backstop the massive deflationary collapse in the economy and asset prices. The Federal Reserve's gold reserve requirement could have been part of the reason why the Fed didn't act to expand its balance sheet until 1932, or maybe not (paper). Let's not forget that protectionist trade policies also contributed to the deflationary forces.
Today, the combination of (unprecedented?) monetary stimulus and deficit spending have so far kept asset prices from collapsing and the economy from contracting since the great recession (2007-2009). But now the question is whether asset price inflation, fueled by releveraging and the Federal Reserve's massive liquidity injections, could actually be positioning the U.S. for another round of deleveraging and deflation when the next powerful negative catalyst hits wire. Some believe this is the reason why the Fed started to reduce its asset purchases (QE) recently.
Look how insane this chart is. So when looking at history, maybe these Dow 5,000 calls, which was a level last seen in the 1990s, isn't really that crazy of a prediction after all.
|Source: @Macro_Tourist via The Trader and His Shadow (blue and gray lines added)|
Related post I found: Could The Stock Market Test A Trend Line From 1843? (Chart)