Deflationary spiral
Deflationary spiral is an economic argument that proposes that a runaway deflation would eventually lead to the collapse of the currency. It is a common criticism made against the viability of Bitcoin.
The ‘deflationary spiral’ is a real condition that affects the fiat fractional reserve backing system. Bitcoin is not affected by this because it is fundamentally different to fiat currency.
Deflationary spiral occurs when the price of a traded article increases at some given rate which causes people to hoard it. As people hoard the commodity, less and less of it is available thus causing the price to go up even more. In turn, even more people hoard the commodity. Thus a feedback loop or spiral of deflation occurs.
In practice, there is only a limited amount of 'value' that can be placed upon a good before it becomes too attractive to trade for other goods (thus ending the spiral). The only time that the 'Deflationary Spiral' can happen (to it's conclusion) is when people can foresee a time where they are forced to use that particular traded article.
In The Fiat Fractional Reserve Banking System
The fiat money that we trade consists of the principle of the loans of other people. All this money must be someday 'repaid.' When people save (pay back their loans), the total monetary supply is contracting. When people spend (take out loans), the total monetary supply is increasing.
If you have people who are hoarding money, the principle still need to be repaid. Hoarding will make it harder for other people in the economy to pay back their loans.
Becasue people foresee a time where they need to pay back their loans (a future fixed expense), when the value of the money starts to increase (deflation), those with loans will endeavour to pay back the loans quicker. This causes the monetary supply to reduce, reducing the total amount of money available for repayment of loans, again making it harder for people to pay back what they owe.
This Deflationary spiral diverts funds away from the legitimate economy, to the repayment of debt. Causing the economy to stagnates and stop.
Bitcoin
The key difference is that people don't foresee a fixed cost (unit amount) that they must pay with Bitcoin. If the value of the Bitcoins that they own increases, then any future cost will take a proportionality smaller amount of Bitcoin. There isn't any fixed incentive to holding Bitcoin other than speculation.
If the economy that uses Bitcoin grows, the per-unit value of Bitcoin proportionally increase also.
Everything is the opposite to the fiat fractional reserve banking system (because Bitcoin isn't a debt but an assist). Bitcoins only deflate in value when the Bitcoin Economy is growing.
Because the Deflationary spiral is a real problem in the traditional monetary system, doesn't necessitate that it can also be a problem in the Bitcoin economy.