The U.S. Capitol building in Washington, D.C. © Kevin Dooley, Getty Images

It just got real.

After years of political posturing, false alarms, kicked cans and a general postponement of responsibility, Washington has finally begun the task of closing our out-of-control budget deficit.

With higher payroll taxes, higher investment taxes, higher income taxes, Obamacare surcharges, and now the furloughs and docked aircraft carriers of the budget sequester, Americans are beginning to feel the sting. (The stock market, for now, seems oblivious to what's coming.)

It will hurt. It will hurt because the economy still stinks for most people, with stagnant wages, higher costs of living and the percentage of the population actually working down to early 1980s levels. And it will keep hurting because, despite the budget progress that's been made, much more must be done to put the Treasury on a sustainable fiscal footing.

Given the current state of our political leadership, this nightmare is set to get worse before it gets better. Here's why, along with a few thoughts on how we can awaken from this bad dream and what investors should do in the meantime.

Just getting started

As I discussed in last week's column ("Why there's no way Obama can win"),  we're only about halfway toward stabilizing the government's finances over the near term, given the 2011 debt-ceiling deal, the fiscal cliff deal with its tax hikes, and now the spending cuts of the sequester. According to the Committee for a Responsible Federal Budget, we need at least $2.4 trillion or so in deficit reduction over the next 10 years to keep debt levels stable.

What's more, this assumes there are no recessions, natural disasters, wars or other drains on the Treasury's finances during that time. If there are, we'll need to tighten more to stay on track.

Anthony Mirhaydari

Anthony Mirhaydari

Already, the tax hikes and spending cuts that have been done are set to chop at least 1.5% off of growth of gross domestic product this year. It could turn out to be more than 2%, since research from the International Monetary Fund shows that, in situations like the one we're in now, deficit tightening hits growth harder than normal. The total drag could easily top 3% if the upcoming fights over a new budget and the debt ceiling result in fresh taxes and new cuts, as expected.

With the U.S. economy essentially flat-lining, and with Japan and much of Europe falling into a new recession, it wouldn't take much of a shove to start a self-perpetuating downturn. (Again, the stock market is marching to its own beat right now due to stimulus from central banks. But, as I discussed in "Gas below $4 or Dow 14,000?", the risks of this strategy are rising while the benefits to consumers are diminishing. And a new recession clearly isn't priced into the market yet.)

If our fiscal chase feels a bit like a dog trying to catch its tail, well, that's because it is.

Following Europe into austerity

You can see this downward spiral playing out in real time across the Atlantic. Europe started its austerity efforts in 2010 after the Greek debt crisis focused everyone's attention on the unsustainable borrowing of many developed-economy governments. The results are plain to see: Government deficits show a modest decline, yes, but at a cost of persistent joblessness, ongoing economic stalling, restless populations, political turmoil and backsliding on austerity commitments.

In other words, austerity has been a failure. The more deeply you cut, the worse your economy gets, which lowers tax revenue, increases benefit spending and widens your deficit whilst irritating constituents. It's a toxic downward spiral.

Fringe, anti-austerity parties are resurgent in Athens and Rome. Hundreds of thousands of protesters have taken to the streets in Portugal, with banners proclaiming "Austerity Kills," demanding the resignation of the current conservative government and an end to the tax hikes and benefit cuts. And Spain and France are asking eurozone leadership for more time to meet the 3% deficit-to-GDP targets Germany has pushed so hard for.

Admittedly, I find European politics as exciting as the average American does. Which is to say, not very.

But just a cursory peek at what's happening there presages where the United States is headed. It's not pretty. And it risks a repeat of the mistakes of the 1937 double-dip recession -- sparked by the misguided belief of President Franklin D. Roosevelt and his conservative Treasury secretary, Henry Morgenthau, that austerity was required to boost the economy. The result was an extension of the Great Depression that didn't end until America's factories ramped up to support the fight against the Empire of Japan and Nazi Germany.

In 1937 and 1938, the budget deficit was closed by a total of 5.4% of GDP. Outside of the drawdown after World War II, a tightening of this scale hasn't happened. Until now: Over the next two years, based on President Barack Obama's 2013 budget proposal, we're on track for a tightening of 4.6%, mainly via tax hikes.

Yet doing nothing, or not doing enough to stabilize the debt load, risks a Japanese-style decline into extreme indebtedness. And that, according the academics, carries risks of a period of stagnant growth, a fragile susceptibility to financial crises and a dangerous temptation to simply monetize the debt via dollar debasement by the Federal Reserve.

Currently, Washington's debt load totals $16.7 trillion, which is now nearly $1 trillion more than the economy's total output in one year. The debt-to-GDP ratio works out to about 105%. In Japan, where debt has been accumulated with aplomb, the debt-to-GDP ratio is expected to hit 230% next year -- creating a reality where economists don't know how the Land of the Rising Sun can reverse its long decline.