In our current system, and that of almost every national economy in the world, debt = cash. That is is a vast simplification, but it boils down to this: The dollars which circulate in the economy (whether paper or electronic) are dollars which are created by various types of bank loans, treasury instruments, etc. When these obligations + interest are repaid, money is taken out of the economy that was previously in circulation. If the entire national debt were somehow repaid, then trillions of dollars will be removed from circulation. If all personal, corporate, and national debt were paid off, we would have no currency left. In fact, because principal on debt is created by said debt, but interest is not so created, it is not even possible to pay off all the debt. There is literally not enough cash in existence to do it.

This is why it is truly a crisis when the lines of credit get "clogged up", as in the present crisis. If the loans don't start flowing again, we are looking at deflation. One can argue whether deflation is good or bad, of course. As I said, it is what it is.

That's true in principle, but in practice inflation makes a difference. Let's say $100 in cash is added to the economy today, and $104 in debt is added at the same time. Next year, inflation will have done two things: it will have decreased the value of the $4 of debt, and it will have increased the rate that new cash/debt is added to the economy. So maybe next year $110 in cash and $114.40 in new debt will be added. The old debt gets paid off, but now we have $4.40 in new debt, but it's "worth" the same amount as last year's debt, so we're even.

Sort-of, anyway. In practice the system isn't so balanced, and the old debt isn't paid off, it just piles up.

One solution is to stop generating new cash this way. Instead, next year the treasury could generate $114 of debt-free cash instead of borrowing it from the fed. $104 of that could go towards paying last years debt, and the remaining $10 would be a permanent debt-free addition to the economy. Eventually all of the debt-based cash could be replaced, and the treasury/congress would be back in charge of our monetary system. There are drawbacks to that approach too (partly why the semi-independent fed was created) but it's constitutional and at least the responsible parties would be elected officials.

But, if the dollar tanks in worth, couldn't that cause inflation? The cost of most of our goods and services in the U.S. are based on goods and services overseas which would go up if the dollar devalued by 20% as some say it might.

However, deflation can also be caused servicing loans when no further loans are being made. Interest is sucking cash out of the economy, and loans are not being made to replace it. Because much of our productivity is based upon the ability to acquire easy credit, such deflation causes a halt to productivity, which leads to a further inability to service existing loans. Default follows, with the flotsam of toxic assets in its wake. Very bad news.

In a central bank system, both forms of deflation inevitably lead to inflation. The hope of central bankers is to control the currency supply such that just enough cash is added in the form of loans to keep the system solvent. However, central planning of an economy never works, and thus we come to the latter form of inflation, which is what we were experiencing just before the bundle of bailouts from the lest several years.

In the latter form of deflation, not only is the dollar perceived as worthless, but it is further devalued by the reactionary inflation which is invariably used to "solve" the crisis. So as you can see, inevitably it is inflation that causes the cost of overseas goods and services to increase.

You have to consider why exactly it is that the cost of goods and services overseas would normally be going up:

China is holding has bought vast sums of US Dollars in order to keep their currency low in relation to the dollar. By buying lots of dollars, China exchanges dollars for Yuan. Yuans flood the market, but China locks up the dollars in the bank. Yuans are inflated. The Dollar is deflated. The Dollars still exist - but they are not in circulation. If China were to liquidate their reserves of US Dollars, this would result in massive inflation. But China can only keep this up for so long. If we flood the market with dollars faster than China can buy them relative to its own currency, this strategy will fail, and eventually China will be forced to liquidate its dollar reserves. This will have the effect of driving the price of the Yuan up, and the Dollar further down.

The problem I see with this is that when the U.S. pumps more money into circulation by buying up U.S. treasury bonds, etc., it further devalues the dollar. The Chinese (and Russia, India, etc.) know this well, and are perfectly happy with this. They'll continue to watch us devalue the dollar. Later, if we try to pull anything, they'll use the money they've amassed to buy up an overwhelming military force. But obviously, they'd rather own us than fight us. Not that they are set on world domination, but when the idiot on the block keeps lowering the cost of his mansion, and you'd like to have that mansion, you'd be stupid not to let him lower the cost until you can buy it for 20% off (or more).