So the short answer is actually two-fold: government spending as a percent of total GDP is low and household debt has been declining, which is deflationary.
Household debt declined by writeoffs not by repayments, hence money supply was destroyed correct?
Interestingly, it doesn't matter whether by write offs or repayments. Either case is deflationary. This is due to the fact that money is created when credit/debt is created. When the debt is paid off, or the credit repaid, the money is then destroyed. The same occurs in write off.
there is the factor of the fractional reserve though involved here, as by writeoff the bank cannot lend the money that would get by repayment again.
That's sort of true. Interestingly, banks can lend up to the limits of a certain multiplier of their capital (assets). That's what fractional reserve means. It's a multiplier of assets, above the assets. They never state it that way though. The statement is that capital must be at least 10% of outstanding loans, or that the capital ratio must be at least 10%.
The funny thing is that loans on an item with a known market price, say a house, become an asset to them. They have created a contract that gives them access to that asset. So the loaned amount becomes an asset on the books.
So the really nice thing for the bank that can loan at 10x assets is that when you borrow $100.00 from them, they have given you $100, but their asset base now allows them to loan another $900. They love you! They'd like thousands more like you to walk in the door. There is no end!
There is no end that is unless the assets begin to decline in book value. When they decline, for every $1 the assets decline, they must remove $10 from their capital.
The contract only allows them to take the current principal amount plus any interest owed from the asset. So as you pay the loan off, their assets decline slowly, giving them time to recover from that by creating more loans.
When the market place reprices bad assets, like when house values rapidly decline, this affects the bank more drastically. That creates a rapid asset (and capital) decline, which can easily cause a bank to go under, mainly because at the same time, no one is borrowing anymore. It's a crash!
Interestingly, during a crash, the money supply is declining and more of the physical asset is becoming available. If this is allowed to take it's normal course, the normal market system will re-adjust pretty rapidly. Money is able to purchase much more than it did before, so the bad assets will be sold off (although at lower prices). And then the market discovers the real price for the assets, as well as the real price for money (interest rates).
Unfortunately, during this process, many banks might go under. I say unfortunately because most people trust banks for their savings and essential monetary needs. This means that the banks "must be saved" in the minds of country leaders and the very wealthy. You can see where this leads...
What I'm really saying here is that the banking system has the seeds of recession and depression built right into it.
A better answer is free market money. Which is why we are all here.
-MikeMark