The National Federation of Independent Businesses has updated their small business survey for December, and once again, the small businesses identify their major problem as “poor sales.” This has gone down somewhat over time, but it still ranks as the biggest problem small businesses face, ahead of taxes, regulations and everything else. As Bill McBride writes, “In good times, small business owners usually report taxes and regulation as their biggest problems.” This is a conservative subset, after all. And they’re still worried most about the lack of demand.

Government has a responsibility to fill that demand gap when times are tough, and investment, consumer spending and exports are lagging. Government becomes the demand generator of last resort in that scenario. And they are just not stepping up to the plate. The emphasis on the budget deficit, in fact, has led to a net drag from fiscal policy on the economy. Goldman Sachs (which actually does good macroeconomic analysis, if there’s one thing they know, it’s money) has released its latest chart showing how much fiscal policy is taking away from growth now and in future years. You can see the chart above.

As you can see, fiscal policy, between state and local government, is providing roughly a 0.6% drag on GDP in this quarter. Fiscal policy went negative in the 2nd quarter of 2010, and has been dragging on growth ever since. This is what I mean about a public sector depression. State and federal government have been dragging down the economy for 8 quarters, and that’s expected to continue for some time, through the end of 2013 according to this chart. In fact, while state budgets almost go back to normal by the middle of this year, fiscal policy gets considerably worse at the federal level in FY 2013, when the spending cap and trigger cuts from the debt limit really start to kick in.

And this could get worse. The dotted line on the chart indicates what would happen if Congress does not pass the payroll tax cut through the end of the year, along with unemployment benefits. However, and this is important, Goldman makes the prediction that unemployment benefits will get cut back from 99 to 79 weeks. In fact, this has already happened in the first payroll tax/UI deal. Technically there’s an Extended Benefits program for that additional 20 weeks, but because of the technicalities around the program, no states will qualify within a few months of this year (states are scrambling to stay eligible as long as possible).

So even in a best-case scenario, unemployment benefits will get cut back in high-unemployment states, taking by Goldman’s estimates $15 billion out of the hands of needy jobless workers in 2012. And since roughly $170 billion will have to be found to finance the payroll tax cut (it shouldn’t be required, but Washington is still on this deficit kick), unemployment extensions and the doc fix, that raises the possibility of more contractionary fiscal policy.

So when you look at Europe and scoff at how they are destroying their economies through austerity, understand that this government has initiated a milder form of austerity themselves. And it’s had precisely the same kind of effect on the overall economy – a sharply negative one. The economy, mired in a slow recovery, cannot afford this kind of unnecessary battering from the public sector. But that’s what they’re getting.