How can Europe escape Japan’s ‘long and winding road’ to deflation?

This was the question Japanese central bank governor Masaaki Shirakawa set himself at the London School of Economics yesterday evening.

With 1 percent growth in Japan per year over the last decade, Shirakawa said that there were lessons to learn both from Japanese society and monetary policy since the early 1990s.

Central banks ‘buying time’

With the scare of the European debt bubble bursting, the governor said that the role of central banks as ‘lenders of last resort’ is more important than ever before.

‘Central banks are not only responsible for their national economies, their policies have global implications,’ said Shirakawa.

One ‘key lesson’ from the Japanese banking crisis is that the Japanese authorities did not allow the disorderly failure of financial institutions, most notably 2.7 trillion yen (around 23 billion euros at that time) to the brokerage Yamaichi Securities, he said.

It is important for central banks to ‘buy time’ through providing liquidity to financial institutions – yet this time, the governor added,  will become ‘progressively more expensive’.

‘Social decision’

A second key lesson from Japan is how to change the mindset of a society facing deflation risk, said Shirakawa, adding it was a question of social priorities.

He said that one of the reasons behind deflation in Japan was a social decision to adjust wages ‘in a reasonably flexible manner, reflecting society’s preference to prioritize employment.’

Unemployment in Japan peaked at 5.4% since 1990 – a far cry from the double figure digits looming in Europe and the US.

The implications of a burst debt bubble in Europe reach globally, said Shirakawa adding that the European sovereign debt crisis is comparable to the systemic risk from the Lehman banking crisis.

‘Japan never became the centre of a global financial crisis.’

The European Central Bank will announce its rate decision for next month tomorrow. Having cut rates in November and December, no change is widely expected for tomorrow's meeting.

The current question for central banks, said Shirakawa, is 'how to restrain excessive risk taking' whilst 'securing profitibility of financial instiututions.'

The full paper can be found of the Bank of Japan's website.