Germany's, and it's leader Angela Merkel's, insistence that austerity is the solution to the soverign debt crisis is rapidly pushing Europe towards a depression. Ultimately, Germany will only bail out the rest of Europe once it sees real austerity taking place. Germany is insisting that to form a closer fiscal union, EMU members must agree to harsh deficit reduction plans. These harsh reduction plans are what will actually cause a depression.
By requiring France, Greece, Portugal, Spain, Italy, Ireland, and the rest of the EMU to reduce spending dramatically, mini depressions will occur in each nation. Government spending in each of these nations plays a major role in the economy. Austerity will significantly reduce government spending in all of these nations, this will lead to workers getting paid less and state workers getting laid off.
The increase in the unemployment rate and underemployed rate will lead consumers to cut spending and default on loans. The default on loans will be yet another terrible headwind for Eurozone banks; sovereign bonds might be guaranteed by the EU, but the non sovereign debt that the banks own will quickly become as bad if not worse than sovereign debt. The reduction of consumer spending will lead to a decrease in imports from China. A reduction in China's exports to Europe will be catastrophic for the Chinese economy.
Ultimately, the U.S economy will not avoid the terrible economic issues that will be brought about the EU austerity. For this reason, US investors should sell stocks and other risk assets if Germany gets it's way with massive spending cuts throughout the EU.
There still remain other viable options that would allow Europe to avoid a depression. The first option is massive money printing by the ECB, but Germany seems unlikely to allow large scale ECB intervention without austerity. Another option is a bail out from China, this also seems unlikely because of the problems the Chinese are already dealing with at home in China. The other option is the Soros plan, which I believe is the best plan to save the world from a depression.
Investment action, if austerity is the solution:
- Sell risky assets, such as stocks (S&P 500) and commodities (even gold and oil)
- Get long the U.S. dollar (UUP)
- Get long U.S. Treasurys (TLT)
- Get long volatility (VXX, TVIX)
And here's a way to invest without knowing whether Germany will allow money printing or force austerity.
Disclosure: I am long TVIX.