Not long ago, a member of our Inner Circle asked a question that’s too broad for a simple answer:

“With its large and cheap labour force, China has been exporting deflation to the rest of the world. It seems that this trend is now reversing and China will be exporting inflation. Chinese workers are demanding higher wages and are becoming consumers. What strategy can you suggest to prepare for this eventuality?”

It seems to me that the biggest sources of world inflation and deflation are much broader than China’s contribution.

On the one hand, the major source of inflation is today’s fiat money system. Governments around the world can create new money whenever it suits them. They can do that directly, by printing banknotes. Or they can do it indirectly, by allowing central banks to expand their credit by writing cheques on bank accounts whose only asset is the government’s borrowing capacity.

Whenever a government creates new money, it increases the potential for inflation in its home currency. When the U.S. does it, it increases the potential for worldwide inflation, since the U.S. dollar serves as the main asset of central banks around the world. However, the new money will have little effect until it goes to work in the economy. We need faster economic growth than we now have to turn that inflationary potential into rising prices.

On the other hand, today’s main anti-inflationary, or deflationary, influence is rising productivity. That comes out of expanding world trade and improving technology. China’s low-priced exports helped to hold back inflation in the past few decades. But Chinese exports may have less of a deflationary influence in the next few decades, due to rising Chinese wages. However, world trade is likely to keep expanding and technology is likely to keep improving. That will have far more influence on world inflation than wage trends in China.

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Investment advice: A few natural inflation hedges should be sufficient for Canadian investors

I think we’ll see more inflation in the next couple of decades than in the last few. But the U.S. and other countries could head off some of that inflationary potential with across-the-board tax reform.

In many developed countries, tax rates have gone too high, and tax rules have become too complicated, for economic efficiency. If countries simplify their tax systems, businesses will be able to focus more on producing goods and services, and pay less attention to avoiding taxes. That would bring on a sudden jump in productivity.

When a problem such as the world’s inflationary potential gets a lot of attention, it rarely, if ever, develops the way most people expect it to. That’s why I advise against making any dramatic efforts to protect yourself from inflation.

For most Canadians, ownership of a family home provides a substantial inflation hedge, and it also comes with substantial tax benefits. You also have an inflation hedge in the Resources sector of your portfolio, because resource prices tend to rise along with inflation. To top it off, well-established companies tend to manage their businesses so that they profit from inflation, or at least insulate themselves from its worst effects.

Owning a home and a Successful Investor-style investment portfolio doesn’t provide perfect protection against the risk of rising worldwide inflation. But it does provide a good balance between doing too little to protect yourself and doing too much.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members

What measures have you taken over the years to protect yourself against inflation? Were they effective? Would you take a different approach now if you saw a quick rise in the inflation rate? Let us know what you think.