April 10 (Bloomberg) -- In 1998, Japan's banks were on the brink of bankruptcy and its credit market was seizing up. While some at the Bank of Japan favored rescuing the system with an infusion of cash, Masaaki Shirakawa wasn't among them.

Shirakawa's economics training at the University of Chicago 20 years earlier had taught him that the role of central banks was to keep prices stable, not provide bailouts. He ``recognized that it could weaken the market's ability to function by itself,'' said Hiromichi Shirakawa, no relation, who was then a BOJ official and is now chief economist at Credit Suisse Group in Tokyo.

With his confirmation yesterday as the Bank of Japan's new governor, Masaaki Shirakawa brings that same University of Chicago sensibility to the world's second-largest economy at a time when Goldman Sachs Group Inc. and Morgan Stanley say it is already in recession.

Investors who have priced in a 34 percent chance the bank will cut its overnight lending rate from 0.5 percent before the end of the year may be misreading Shirakawa, the Credit Suisse economist says: ``We're telling clients we don't expect a cut.''

Shirakawa, 58, a 34-year Bank of Japan veteran, wasn't supposed to become governor; he was named deputy only four weeks ago. But the opposition Democratic Party of Japan, which controls the parliament's upper house, blocked two candidates proposed by Prime Minister Yasuo Fukuda and his Liberal Democratic Party. The DPJ said the other candidates' affiliation with the finance ministry compromised the bank's independence.

Unchanged

Fukuda finally nominated Shirakawa for the top job on April 7 and the Diet approved him yesterday as he chaired a policy meeting at which the bank kept its key lending rate unchanged.

``One of the things that makes a great appointment is when the appointee isn't lobbying for the job,'' said Jacob Frenkel, a teacher of Shirakawa's at Chicago and former governor of the Bank of Israel who is now vice chairman of American International Group Inc. in New York. ``Shirakawa wasn't a candidate of any political party. He doesn't owe anybody anything.''

Shirakawa got his master's degree in economics in 1977, when Milton Friedman was a dominant presence at the university. A 1976 winner of the Nobel Prize, Freidman was a proponent of low inflation and a disciplined central bank.

At the time, the U.S. was headed toward a period of stagflation, with unemployment averaging 6 percent in 1978 and inflation 7.5 percent. Friedman and others at the Chicago school pushed for the idea that the central bank's job was to fight inflation by controlling the money supply and no more.

`Printing Money'

``There was a belief that inflation is a monetary phenomenon caused by government policy, basically printing money,'' said Gary Becker, a professor of economics at Chicago since 1970 who won the Nobel Prize in economics in 1992.

What Shirakawa brings to his new job from his school days is a recognition that well-functioning markets are at the heart of a well-functioning economy, Frenkel said: ``If you have these foundations in place -- financial institutions and strong financial markets -- then you can rely on the market to guide the economy.''

Masaaki Kanno, 58, a former Shirakawa colleague at the BOJ and also a student of Frenkel's in Chicago, said Japan's late- 1980s asset bubble, like the previous decade's U.S. stagflation, provided a real-world lesson in the new governor's economic education.

From February 1987 until April 1989 the Bank of Japan kept its overnight lending rate at 2.5 percent, feeding land and stock prices. The Nikkei 225 Stock Average peaked on the last trading day of 1989 at 38,915.87 points. The average dropped 1.3 percent to 12,945.30 at the 3 p.m. close in Tokyo.

Similar Causes

``The problems were different but the causes were the same: Easy monetary policy that lasted too long,'' said Kanno, now chief economist at JPMorgan Securities in Tokyo.

The idea that the market is the best mechanism for picking winners and losers may also explain Shirakawa's reservations about the central bank's 2001 policy of holding interest rates near zero and pumping cash into the financial system. At the time, policy makers were trying to lift the economy out of deflation and jump-start bank lending.

``He was in charge of executing the board's policy but he didn't like it,'' said Credit Suisse's Shirakawa, who met with the then-executive director in charge of monetary policy in 2002. ``He said that he believed zero rates were creating bias, or distortions, in the market.''

At Peace

Shirakawa left the bank in 2006, and was teaching at Kyoto University when Frenkel last met with him over dinner two months ago. ``The guy was at great peace with himself,'' Frenkel recalled. ``He said, `You know, now I can spend my time with the thing I like most: economic science.'''

The job ahead is more than academic. Investors are betting he will have to cut rates as Japanese exports falter on the back of the U.S. slowdown. The Organization for Economic Cooperation and Development said this week that Japan's growth will slow this year to 1.6 percent from 2.1 percent in 2007.

Shirakawa told parliament this week that the central bank needs to pay ``full attention'' to risks the economy faces over the medium to long term.

``There are plenty of cases in which central banks have prioritized short-term management of economies'' and have taken measures that hampered growth, he said. The bank sticks to its prediction that Japan's economy will regain momentum after a temporary slowdown, he said.

``He takes a long-term viewpoint,'' said Kanno. ``He looks to maximize long-term gains even if it means pain in the short term.''

To contact the reporter of this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: April 10, 2008 04:43 EDT