Money Can Indeed Perform Vanishing Acts
You used to see it, now you don't.
It's incorrect that "dollars are destroyed" when debt is defaulted upon.
Let me give you an example: Bank XYZ lends Joe $1,000, creating "money" from thin air. Joe spends the $1,000, buying a car from Carl. Later on, Joe defaults.
Have the $1,000 magically disappeared? No, they remain in the economy (if Carl hasn't spent them, he remains in possession of the $1,000).
The only way the money could disappear was if:
1. Joe pays the loan back or
2. Banks were to go bankrupt in such a way that their deposits disappear (this would require not only the bankruptcy of the FDIC, but also the bankruptcy of the US Treasury, which backstops the FDIC).
The most strictly defined measure of money supply is money AMS, which avoids the double-counting inherent in broader money measures that count not only money but also credit transactions, and also avoids counting the "idle bank reserves" on deposit at the Fed, recently stood at an annualized growth rate of 14.5%.
This means that today, there's 14.5% more money in the US economy than one year ago.
This isn't deflation. Deflation would be a decrease in the money supply -- no such decrease has occurred.
Interestingly, in spite of the fact that bank-credit growth and consumer-credit growth have actually turned negative, there isn't less debt in the economy than one year ago -- on the contrary, total credit-market debt has exploded in parabolic fashion as the government has increased its outstanding debt (much of it immediately monetized by the Fed) at multiples of the decrease in private-sector debt.
There may be deflation at some point in the future if private-sector debt repayments were to overwhelm borrowing by the government and the monetization of assets by the Fed, but this remains highly unlikely in an unfettered fiat money system.
What's definitely certain is that there's been no deflation to date -- all that's happened is that a fall in asset and commodity prices has created fear of deflation (ironically at precisely the same time monetary inflation went through the roof).
A 14.5% increase in money AMS in one year is among the highest inflation rates of the post World War II era (although still 5.5% shy of the Greenspan record set in 2001).
Debt defaults will forcibly decrease the amount of credit in the system, and will lead to impairment of lender capital through losses, but they won't destroy the money that's been issued. This money will remain in the economy.
It remains to be seen whether debt defaults and credit repayments combined can actually overwhelm government borrowings and lead to a net decrease in outstanding credit (the Japanese experience says no, it won't happen).
In a pure fiat money system, inflation is a political decision; as an example, Zimbabwe managed to engender hyper-inflation in spite of the banking system not issuing a single private loan for two years and the industry being in a state of complete paralysis. The central bank simply monetized enormous amounts of government debt, and the government pushed this money into the economy.
This is not to suggest that the US is going the way of Zimbabwe, it merely serves to illustrate that as long as the government and the central bank are willing to do so, inflation can be created anytime.
However, no one expects the nominally independent Fed to go down this path; it is correct, in principle, that falling asset prices and negative economic data are pressuring the dollar higher as debt repayment becomes more difficult, resulting in a temporary scramble for dollars.
In addition, because of 0% interest rates, the dollar has become a funding currency for speculation in stocks, commodities, and higher-yielding currencies. Falling stock and commodity prices thus create margin pressure that increases the demand for the major funding currency for these carry trades.
None of this changes the fact that as of yet no deflation has occurred -- both the money supply and outstanding debt have continued to increase at vigorous rates over the past year.
I wanted to address in more detail something the above writer sent in. I agree with almost everything he says, but there are some nuances that are important. In trying to explain the situation simply to readers I've glossed over some of this nuance that he rightly brings up. None of this is straightforward, which is why very intelligent people can totally disagree on the deflation/inflation debate.
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