A Stronger Yen is Pummeling Japan

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Despite cheaper labor in Vietnam, China, and other developing countries, domestic production still accounts for at least half of total sales at Sony (SNE) and Canon (CAJ). Tech companies and automakers alike say it's important to maintain some manufacturing in Japan to be close to research and development labs. And they say producing at home helps keep innovations and new ideas from falling into rivals' hands.

Japan's policymakers bear some responsibility for the problems, too. Under former Prime Minister Junichiro Koizumi, the government slashed spending programs that had been aimed at reviving the economy after the collapse of the early 1990s. That might have been fiscally prudent, but it cut into domestic demand and boosted the importance of exports for growth. Today, with Japan's longest postwar expansion at an end, the weakened domestic economy can't cushion the blow as companies cut back on investment and exports hit the skids.

Then there's Japan's ultralow interest rate policy. For five years until July 2006, the Bank of Japan kept its benchmark rate at virtually 0%, and as the economy recovered it raised rates to just 0.75%. That contributed to what investors call the carry trade—borrowing yen for next to nothing and investing in higher-yielding securities abroad. As everyone from housewives to hedge fund managers bought foreign currencies to do just that, the yen weakened, which made Japanese goods cheaper and inflated profits for Japanese corporations. But as the yen started to recover last year, investors rushed to sell their foreign assets, pushing the Japanese currency ever higher. "We had a cheap yen bubble, and now it has burst," says Eisuke Sakakibara, a former top official at the Finance Ministry and now a professor at Waseda University in Tokyo. "Not raising interest rates earlier was a major mistake."

Some experts trying to find a way out of the mess are calling for the Finance Ministry to intervene to halt the yen's rise, which would provide an instant tonic to exporters. And in the absence of a global recovery, economists say Tokyo must boost spending to spur growth. "Everyone realizes the government has to keep the economy from collapsing," says Richard C. Koo, chief economist at Nomura Research Institute in Tokyo.

The malaise gripping Japan was in full view in Hibiya Park over the New Year holiday. Volunteers converted part of the park into a tent village, providing free food and shelter for some of the 85,000 temporary workers who have been laid off in recent months. But the 250 beds were quickly occupied, and the Health, Labor & Welfare Ministry was forced to open an auditorium in its building to provide extra shelter. Given the economic downturn and the difficulties faced by temporary workers, said one volunteer, a 61-year-old retired teacher who asked not to be named, "I thought I should do something."

Rowley is a correspondent in BusinessWeek's Tokyo bureau
With Hiroko Tashiro .