Mike, think of it this way:
1. Classical economics says that the money supply expands during a credit expansion, and contracts during a credit contraction.
2. We agree that prices are based on supply and demand.
3. Since the supply of money is expanding during the credit expansion, and contracting (sort of) during the credit contraction, many economists, regardless of ideology, assume that prices rise during the credit expansion, and actually fall during the credit contraction.
Whether they actually do or not is another matter; the question is, have I fairly described the situation in broad terms up to now?
4. Item #3 is a result of people thinking in terms of WORDS, not PICTURES. Some of us, due to brain damage or lopsided brain architectures or whatever, think in terms of PICTURES not WORDS. I think in terms of imagining loans being made, money flowing through an economy, people manufacturing and buying/selling stuff, etc.
Words like "deflation" are poorly-defined for us, because we have difficulty mapping the word to an accurate picture of what is going on.
Here is how I model the situation in MY head (switching to Roman numerals to distinguish a different way of seeing the situation):
V. During the credit expansion, it's true that the money supply expands, but the "debit" side of the balance sheet is expanding right along with the "credit" side.
VI. Something else that's expanding--and this is the part that the Keynesians in particular miss--is productive capacity.
People aren't just borrowing money for pure consumption; a lot of the credit creation is going into loans to start new companies. Consumption increases but so does production.
It would seem as though you can expand consumption faster than production, but there are some natural dampeners on this process. I call one of these dampeners "you don't need two toasters". More money circulating does not imply that people rush out to buy extras of everything!
One thing that does happen is that a certain amount of consumption moves up the luxury scale. Many Chicago-School and Austrian economists overly-fixate on the reverse of this process: they can't imagine prices going up because they tend to assume that all consumption is infinitely "elastic".
It's not. When there's not enough wheat in the world, you don't substitute "something cheaper", you starve to death. It's not like the global supply of potatoes suddenly swells to make up the difference!! Instead, you find the price of potatoes suddenly shoots up too. The cheaper "substitute" (potatoes are only a substitute for wheat in terms of calories, not actual bread production or even food value) can not simultaneously fill the void and stay cheaper at the same time, nor does its supply suddenly increase. Even items whose production can be expanded--and not all can!!--take time to ramp up production.
VII. During the credit contraction, credit contracts BUT SO DO DEBITS. Loans get written off. I think it's true that there is more demand for money to repay debt but only to the extend that the ephemeral fiction that the debt is going to be repaid endures--which isn't all that long.
In order to continue the illusion as long as possible, there is a certain amount of central bank interference--but it consists of more credit creation!
VIII. During the credit contraction, credit contracts BUT SO DOES PRODUCTION. It appears that production falls faster than credit contracts! A small contraction in credit bankrupts a lot of businesses! There is some sort of implicit expectation among the deflationites that bankrupt factories continue to churn out goods.
They don't. If they are kept open as zombie businesses that implies MORE CREDIT CREATION. But not all companies are bailed out: the priority has been to bail out just certain segments of the economy. So, a lot of production collapses.
Now we're back to the fallacy of substitution. Not enough wheat implies that the supply of potatoes magically expands.
Wheat prices are rising, not falling. The deflationites imagine something to be happening, that goes against the evidence. POTATO PRICES ARE RISING.
Demand is not infinitely elastic. People want to continue eating during recessions. They also continue driving. Bailouts and subsidies actually make the problem worse! Expanding the social welfare system so that granny can continue her discretionary driving to bingo at the new community center puts MORE UPWARD pressure on prices.
Prices of "manufactured items" (as opposed to financial assets, which are somewhat "fictitious" (the oversupply of houses is not an "asset" it's a "waste" of houses sitting empty; the longer they sit empty the more their potential value is sliding back to zero not whatever they are on the books as)) are rising, not falling, exactly as I would expect from my mental models. BTW, the oversupply of empty houses does not impact rent, at least not beneficially. Rents are starting to creep back up, at least for those actually paying it, and not getting a free ride from a broken foreclosure process.
IN THE END, EVERYTHING MAKES SENSE THE WAY IT IS BECAUSE THERE ARE REASONS FOR IT. You just have to account for all of them.
