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FRANKFURT/WASHINGTON (Reuters) - Meeting students at the University of Amsterdam in April last year, European Central Bank President Mario Draghi extolled the virtues of courage, recalling a story his father had told him:
"In between the wars, he saw an inscription on a German monument, a German statue saying that 'if you lose your money you've lost nothing, because with a good business you will take it back; if you lose honor, you've lost a lot, but with good heroic action you can get it back; but if you've lost courage, you've lost everything.'"
Draghi showed his steeliness at the height of the euro zone crisis, vowing to do "whatever it takes" to save the currency.
Now investors would like him to show the same mettle again and take bold policy action to buoy the euro zone economy and steer it away from the economic quicksand of deflation. With no 'shock and awe' policy move in sight, they may be disappointed.
Draghi has shelved one bite-sized measure the ECB had discussed, essentially thinning its armory to a "big bazooka" - U.S.-style quantitative easing that would be difficult for some ECB policymakers to stomach - or nothing.
The risk is that the ECB fails to act early and aggressively enough, and that a cocktail of downward cost pressures sucks the economy into a quagmire of falling prices.
So far, the ECB insists inflation expectations are sound, or "anchored" in central bank parlance, and there is no risk of deflation, which would lead households to defer purchases, crimping demand and entrenching a downward price spiral.
But the situation is fragile and could change quickly.
"You should not be over-reassured by the fact that expectations are still anchored, and I would add that when you find out that they are not anchored any more it may be too late," said Francesco Papadia, a former director general for market operations at the ECB.
The example of Japan, which has been mired in deflation for 15 years, offers a frightening precedent. Price declines there were so mild to start with it took a long time for the Bank of Japan to acknowledge that deflation had set in and that it was dangerous enough to require a strong policy response.
There are striking parallels between 1990s Japan and the euro zone's plight now: weak bank lending, fragile economic growth, a rising exchange rate, and the central bank's insistence that deflation is not on the horizon.
ECB Executive Board member Benoit Coeure, who speaks Japanese and knows the country well, warned on Thursday about banks rolling over bad loans, what he called "zombie lending", as they had done in Japan. "We've seen a risk of Japanification of the euro zone," he said in Paris.
There are some differences between the economies: with an ECB-led health check of its banking sector, the euro zone is being more proactive than Japan in cleaning up its banks. And there is no sign yet of European consumers deferring purchases.
"The situation in the euro area is different because inflation expectations are firmly anchored, whereas they were not in Japan," Draghi explained after the ECB's March 6 policy meeting in response to a question from Reuters.
The International Monetary Fund is more concerned and has urged the Frankfurt-based central bank to take action such as an interest rate cut or even quantitative easing.
Adam Posen, a former Bank of England policymaker who now runs the influential Peterson Institute for International Economics in Washington, also says the ECB should do more.
"Deflation ... doesn't move very much. When it gets low, it will stay low. We can see now how hard it is for Japan to move (inflation) up just a couple of percentage points. So the ECB is accepting too much risk of them getting stuck at where they are now," he told Reuters.
Draghi himself has warned of the risk of inflation becoming stuck in a "danger zone" below 1 percent.
ECB staff forecasts released last week showed euro zone inflation quickening from 0.8 percent last month to 1.5 percent in 2016, when it would hit 1.7 percent in the final quarter.
That would see inflation just about hit the ECB's target of "close to but below 2 percent" within its policy-relevant medium-term horizon. But inflation is notoriously difficult to forecast over longer periods.
"The experience of Japan is sobering here because nobody expected that Japan would have some 15 years of inflation bordering with deflation: our ability to forecast inflation over the medium-run is poor," said Papadia.
Andrew Bosomworth, a portfolio manager at Pimco, the world's largest bond fund, says a shock to the euro zone economy could easily blow the bloc's fragile recovery off course and send it towards deflation.
"Another negative external shock would certainly tip the scales," he said.
That certainly happened in Japan in 1997, when a toxic mix of tighter fiscal policy and the Asian financial crisis plunged the economy into recession and pushed it deeper into deflation.
Emerging market turmoil poses the biggest such risk for the ECB, with Draghi saying last week that tensions over Ukraine "could quickly become substantial and generate developments that are unforeseeable and, potentially, of great consequence".
Such turbulence, coupled with policy inaction from the ECB, risks further boosting the euro, which hit a 2-1/2 year high against the dollar after the ECB last week left interest rates on hold and unveiled no other policy measures.
"The recent appreciation of the euro has had indeed a strong disinflationary impact," Bank of France chief Christian Noyer said on Monday, adding that "permanent and deep forces" were weighing on inflation in the euro zone and wider world.
Other ECB officials share Noyer's concerns and would prefer a lower exchange rate. Spanish central bank chief Luis Maria Linde said on Wednesday: "If the euro keeps appreciating against the dollar, that could lead to additional measures."
ECB policymakers insist they still have policy tools available if they see a risk of inflation expectations veering off track. But the realistic range of options is limited, as is their potential impact.
The ECB's main interest rate is already at a record low of 0.25 percent, and the deposit rate it pays banks for holding their money overnight is at zero.
A cut in the main rate would likely mean pushing the deposit rate into negative territory, which would mean charging banks for parking their deposits at the ECB in the hope they would instead lend some of the money to firms and consumers.
Some policymakers have reservations about this scenario as banks could respond by cutting the interest they pay savers. It could also potentially disrupt the interbank lending market.
A more "bite-sized" option would be for the ECB to stop operations to soak up money spent on Greek and other countries' bonds at the height of the euro crisis. This would release some 175 billion euros ($245 billion) into the financial system.
However, Draghi last week played down the benefits of this technical option for loosening lending conditions, suggesting the ECB will either do nothing or else take bold policy action should the outlook deteriorate.
Quantitative easing (QE) - printing money to buy assets - would be such bold action, and it is a measure some ECB policymakers have mentioned as an option.
However, hawkish members of the 24-member Governing Council believe the barriers to embarking on QE are particularly high.
On a more technical level, some officials also ask whether U.S.-style QE would have the same impact in the euro zone, where they see less evidence of a link between interest rates on sovereign bonds and lending to the private sector.
For now, the ECB argues its 'forward guidance' on rates remaining low for an extended period creates a de facto loosening of its policy stance as an expected pick-up in inflation would bring down real interest rates.
Draghi struck a more dovish tone on Thursday, saying the ECB would counter any material risk of inflation expectations becoming unanchored with fresh policy measures, which he said the bank had been preparing.
But he described deflation risks as "quite limited".
The Japanese experience shows that a defensive approach to deflation risks can see a major economy come unstuck.
Consumer prices in Japan began to slip in 1999, by 0.3 percent, followed by a 0.7 percent fall in 2000, but it took until 2001 for the central bank to deploy quantitative easing.
Prices fell 4.1 percent in the 15 years to 2012, an average of 0.3 percent a year.
The BOJ has long argued that deflation was only a symptom of a structural malaise such as an ageing population. It also held doubts on whether flooding markets with cash would push up prices, a suspicion still shared by some central bankers, including those at the ECB.
The foot-dragging took its toll.
A prolonged period of sticky deflation sapped Japan's economic strength by encouraging companies and households to hold on to cash rather than invest. Japanese firms are still sitting on 230 trillion yen ($2.25 trillion) in cash, nearly half the size of the country's economy.
Cyclical booms in the economy didn't last long enough to change the public's perception that prices would continue to fall, making deflation self-fulfilling.
"The ECB is wrong, making much the same mistake the BOJ used to make, which is to assume that everything is a structural problem, that nothing is cyclical and that you're doomed to low growth and therefore any monetary expansion will be rapidly inflationary," said Posen.
Japanese officials are dispensing advice on how to counter deflation. Finance Minister Taro Aso shared Japan's experience with his peers at last month's G20 finance leaders' meeting in Sydney.
"I told them it's very important to take aggressive macro-policy steps to prevent slipping into deflation," he said.
The IMF is also studying what lessons can be drawn from Japan's deflation experience to help the euro zone.
Reza Moghadam, the head of the IMF's European Department said in a recent blog that very low inflation "is working to the detriment of recovery in the euro area, especially in the more fragile countries, where it is thwarting efforts to reduce debt, regain competitiveness and tackle unemployment".
The deflation debate is particularly relevant to countries on the euro zone periphery that are struggling to reduce their debts. Greece is already running a negative inflation rate.
But the problem is perhaps biggest for Italy, the euro zone's third-largest economy, which is saddled with 2 trillion euros ($2.8 trillion) of public debt and is struggling with the competing need both to cut costs and spark growth.
Deflation risk is "linked at the hip to debt sustainability", said Pimco's Bosomworth, adding: "Italy is in a much better position than Japan, but it's got Japan-style demographics and debt dynamics evolving in slow motion."
The European Commission expects Italy's debt to hit 134 percent of gross domestic product (GDP) this year.
The attached graphic shows that even with a solid recovery and higher inflation, Italy will take years to cut its debt to 100 percent of GDP, let alone reach an EU target of 60 percent.
Downward pressure on wages risks lowering inflation, slowing the erosion of Italy's debt pile.
"If Italy does the same sort of internal devaluation that Spain, Ireland, Greece and Portugal have done, then euro zone aggregate inflation is going lower," said Bosomworth. "Europe is very much on a knife edge."
The risk is that inflation expectations swing lower and consumers start deferring purchases. Draghi's predecessor as ECB president, Jean-Claude Trichet, said that is not happening.
"But this does not mean that you do not have to be very careful," Trichet added.
($1 = 0.7180 Euros)
($1 = 102.1300 Japanese Yen)
Additional reporting by Sarah White in Madrid, Krista Hughes in Washington and Leigh Thomas in Paris; Editing by Will Waterman