so in theory reducing the monetary supply and causing deflation.
This statement is too simplistic, as it assumes there is a direct link between the money supply and the price level. Whatever relationship exists is far more complex than suggested by quantity of money theories.
Considering that every time someone pays back a loan, the asset and liability collapse back into a single copy of the money,
This statement is misleading. Under the assumption that a loan is paid back by a transfer from a deposit account, both the loan and deposit disappear. A bank making a loan effectively creates a new deposit/loan pair “out of nothing” (a bank needs capital/liquidity to undertake this, but the loan act creates new assets/liabilities), and paying the loan back reverses the operation.
Loans are expected to be repaid, and they are repaid all the time. The aggregate amount of loans normally rises, as new loans are larger than paid off loans. Therefore, the typical situation in modern economies is that the price level is rising, and loans are being paid back. As such, we cannot observe the effect that paying back loans causing deflation.
In a recession/crisis, loans outstanding (and thus bank deposits) falls. It seems more plausible that the fall in loans is the result if new lending being curtailed than a large number of entities paying back loans. That is a deflationary environment, but one cannot really trace it directly to loans being paid back.