There is a well known function in economics that says that if trade imbalances exist between countries in a free market, currency differentials will adjust to normalize them back into an equilibrium balance. Some question this because they see 'a weaker dollar" but the Trade Deficit is not improving, and is actually becoming worse. Why is this? Is the function no longer valid?
The majority of market punters look at the familiar USDX Dollar Index, quite simply because this is what is traded if you are trading dollar futures.
The US Dollar Index® (USDX®) is a globally recognized benchmark for the performance of the US dollar. Futures contracts based on the USDX are offered exclusively by the New York Board of Trade, and are available for trading on the fully electronic platform of the Intercontinental Exchange (ICE) beginning on June 15, 2007
The U.S. Dollar Index® (USDX®) – the barometer of the U.S Dollar – has been around since 1973.
The New York Board of Trade is the designated futures market and exclusive global marketplace for U.S. Dollar Index® (USDX®) futures and options on futures contracts.
The USDX futures have traded exclusively in the NYBOT currency markets since 1985. USDX futures and options represent useful financial instruments for those who wish to hedge currency risk exposure or to take an investment position in the U.S. dollar without the exposure to a single currency pair.
The Federal Reserve maintains some indices that are 'trade weighted' meaning that the currencies included and the percentages by which they are weighted are based on the level of mutual trade that the countries conduct with the United States.
Let's take a look at the Fed's trade weighted indices, their components, and what they might be telling us.
From looking at this chart, the high and low lines, Other Important Trading Partners and Major Currencies answer two very important questions.
The Other Important Trading Partners is dominated by the Asian export countries, who have adopted a mercantilist industrial policy with regard to the US markets. China, for example, devalued the yuan by a about 40% in 1995, and has maintained currency controls and a dollar peg since then, with the agreement of first the Clintons and then the Bush Administrations. The oil exporters have been maintaining a de facto dollar peg as well.
The reason our trade deficit has not yet corrected is because the major imbalances (but not overall trade) are held with countries that have not yet allowed their currencies to decline significantly against the US dollar. The free market portion of that theory is not being applied. An imbalanced currency peg has a similar effect on 
trade as tariffs and import restrictions and export subsidies, and don't let anyone tell you otherwise because its fairly straightforward math. The fact that both Messrs. Bush and Clinton acquiesced to China without demanding a free market in their currencies, even on a schedule, represented a significant blow to US manufacturing base, but a significant windfall to the financial sector and Wall Street. The fact that economists defend this as benign shows how the financial system has corrupted the economics, regulatory, and accounting professions.
The second important index is Major Currencies. This is what we like to think of as the basket alternative for the US dollar as global reserve currency. For many years the US has been able to maintain a dollar hegemony which, backed up with over 700 military bases around the world, has allowed it to essentially print dollars as the most universally currency, tightly tied with the dollar oil peg with the Saudis, and to a great extent manipulate world finance and trade.
What the British navy was to the British Empire, the US dollar is to the American financial empire, maintained with military muscle.
Think about this a bit, and consider the implications, especially the British experience as they moved from the Victorian era through the 20th century and their colonial empire unraveled, in a surprisingly graceful manner as compared to several alternatives. In a subtle way the United States is in a similar position after the American Century. (cf. The Project for a New American Century of the neo-Cons)
Some believe that the American empire will never decline, and that the dollar can never be replaced as the currency of the world. Where then is the glory of Greece, the grandeur of Rome? Troy, Persia, Alexander of Macedon? The Ottomans, the Byzantines, the Egyptians? Austria-Hugary? Napoleon? the Shogunate? Third Reich? the Chin, Han, and Zhou? the Mayas and Incas? Mongols? Ubi sunt?
All gone. Cremated to ashes on the bonfire of the vanities. What remains are statues, some tools, broken monuments, literature, philosophy, sciences, and their gold and silver coins and adornments. Nothing else remains. The wheel of God's justice grinds slowly, but exceedingly fine.
I met a traveller from an antique land
Who said: Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shatter'd visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamp'd on these lifeless things,
The hand that mock'd them and the heart that fed.
And on the pedestal these words appear:"My name is Ozymandias, king of kings:
Look on my works, ye mighty, and despair!"
Nothing beside remains: round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away.
Ozymandias, Percy Bysshe Shelley
