In one of my college finance classes I had professor who used to say that buying and selling shares of a company's stock was essentially voting on the future of the company. She used to say that every time you bought or sold shares in a company you were casting your vote on how you felt about the company. Well if that holds true, then the same can be said about a nation's currency, after all in my opinion the currency of a nation is essentially the equivalent of its common stock. There are a couple of major items that are a significant influence on the value of a nation's foreign currency. With that in mind, I would like to take a look at them, how they have been impacting our currency, and what should be done to address the issues surrounding those factors.

1. Interest Rates: In a relatively stable economic climate, international investors and other organizations that need to invest spare cash in bonds and other interest rate bearing instruments (think bonds) will generally choose to invest their money in bonds issued by the government and corporations of those countries that have higher interest rates. With highly liquid foreign currency markets they can hedge the currency risk. So the bottom line is that countries with higher interest rates will attract more foreign investments, which in turn will raise the value of their currencies. Conversely those countries with low interest rates have declining currency values. As the US cut interest rates last year, the Dollar continued to decline, and the price of Oil continued to rise. Interest rates matter, and they do have an effect on things. Currently our interest rates are below the rate of inflation. The Fed Funds rate is at 2% and inflation is around 8%, having a negative real rate of interest is depressing the value of the US Dollar. Raising interest rates would strengthen the dollar. Unfortunately, I do not see this happening until the crisis affecting the US financial system is finally resolved, and with the sale of Merrill Lynch over the weekend and the impending bankruptcy filing of Lehman Brothers the recovery is probably still a long ways off.

2. Tax Rates & Tax Code: Finance 101 teaches us that investors evaluate an investment based upon the aftertax returns. Tax rates matter. The higher the tax rate, the less attractive an investment is; and the lower the tax rate, the more attractive the investment is. With the "Bush Tax Cuts" set to expire, the prospect of rising future tax rates is making US investments less attractive. In order to make US investments more attractive internationally, we need to have lower tax rates. This extends to not just income tax rates, but to corporate tax rates and other trade related taxes. We need to stop having a tax code that punishes success and we need to understand that our country does not exist in isolation, but in a world wide community and our tax code needs to be competitive when compared to the tax code of other nations. There is more than enough evidence to show what type of tax code allows a nation's economy perform well and what type of tax code does not. The United States as a nation does not have a competitive tax code. We need to have serious reform to our existing tax code. We need to have a flatter tax code that comes with a high personal deduction, eliminates most other deductions, and contains a single tax rate. Our corporate tax code should also move towards a flatter tax rate and eliminate the taxation of profits on overseas subsidiaries.

3. Budget Surplus vs. Deficit: Whether a nation runs a budget surplus or deficit has a major impact on its foreign currency. As the US government turned from a budget surplus to ever larger budget deficits, the value of the US Dollar has declined. Shrinking the budget deficit and eventually returning to a budget surplus or even a balanced budget will strengthen the US Dollar. In the long run, in order to truly fix our budget problems, the US needs to reform entitlement spending, and strongly limit the growth in discretionary spending.

4. Price of Oil (Trade Balance): Well maybe not solely the price of Oil, but a trade surplus strengthens a currency and a trade deficit weakens a currency. Oil is our largest import in terms of dollars. Oil is paid for in dollars, and when the oil importing nations convert dollars to their currency or Euros, this weakens the US Dollar. Reducing our use of foreign oil will strengthen the US Dollar. (Please see last week's edition of the Sterling Weekly for my thoughts on the price of Oil.) Over the last year as the price of Oil has increased, the value of the US Dollar has decreased. When the Russians invaded Georgia, the US Dollar strengthened and the price of Oil declined. This is the clearest example of the link between the price of dollar and the price of oil. The trade balance can be effected by two (2) main items; the 1st being the US tax code which needs to be less punitive and more friendly to our international companies, and the 2nd being free trade agreements. The US needs to enter into more of these agreements which typically have the effect of opening foreign markets to US goods and services and even the playing field with countries that already have access to our markets.

5. Inflation: I have often said that inflation is a cancer that eats away at the value of our assets. Well, the Dollar is not immune to the detrimental effects of inflation either. Nations that have a high inflation rate always suffer from a declining value of their currency. Simple fact of life. If a nation has a low inflation rate, then your currency will be strong and stable. Concerns over a rising inflation rate have been putting downward pressure on the value of the US Dollar in international currency markets. I am a monetarist when it comes to inflation. This means that I believe that inflation is caused by increasing our money supply too fast. Raising interest rates in effect shrinks the money supply, and combats rising inflation. Bringing real interest rates back into positive territory from their current negative real rate of return will help reduce inflation in the US, which in turn will help increase the value of the US Dollar.

A continually declining currency is not helpful or beneficial to any country. The US economy is the largest in the world, and this has allowed Americans to enjoy the highest standard of living in the world. In order to maintain this leadership position and continue our high standard of living, the US needs a strong and stable currency. In order to maintain a strong and stable currency the US needs to pursue sound monetary policy that includes and appropriate interest rate level that maintains a low inflationary environment that encourages investment and savings, and the US government needs to pursue sound a tax and budget policy that strengthens the economy and not weakens it.

In the upcoming editions of the Sterling Weekly I will be taking a look at the two (2) remaining issues I feel are weighing on the market. If you are not a subscriber, please be sure to sign up in order to see our upcoming comments.