The U.S. economy shrank unexpectedly in the last three months of 2012, ending over 30 months of economic growth. Exports lagged, in part because of declining markets in Europe, now suffering a continued recession inflicted by misguided austerity policies. But the greatest cause of decline was unexpectedly large cuts in government spending, particularly in the military. Yes, Virginia, cutting government spending in a weak economy costs jobs. A three-month downturn is a caution, not a catastrophe. But Washington seems too wrapped in its deficit delusions to pay attention to the flashing yellow lights. Here's a cautionary guide.

1. Austerity costs jobs

This economy is still sputtering. Over 20 million people are in need of full-time work. While corporate profits are at record heights as a percentage of the economy, wages are at record lows and falling. An alarmed Federal Reserve has kept interest rates close to zero. Housing prices have started to come back. But companies are cautious, looking for customers before they do much expansion.

In these circumstances, cuts in government spending and hikes in taxes on working people cost jobs. Government workers and contractors get laid off. Small businesses feel the pinch as the afflicted tighten their belts. Interest rates can't go lower; business doesn't get any more confident. And as the last three months showed, it doesn't take much to push a slow growth economy into decline.

2. More austerity is already being inflicted

Last quarter's decline took place before the tax hikes agreed to in December's "fiscal cliff" deal. The increase of tax rates on the top 1 percent will have little effect on demand, since someone making over $400,000 can afford the hit. But the end of the payroll tax holiday cost the typical family 2 percent of their income, with the change visible in their January paychecks. For a family earning $50,000, that represents a $1,000 loss of income — and will be felt.

3. Even more austerity soon come

House Republicans devoted their retreat to reordering the serial fiscal hostage taking they have planned for the next five months. The proper etiquette of hostage taking, they determined, begins with the threat of deep automatic cuts of military and domestic spending — the sequester — on March 1, then moves to the threat to shut down the government by the end of March, and finally to the threat to default on the national debts and shudder the global financial system in mid May. This reordering, they believe, gives them greater leverage to extort deep and unpopular cuts in spending, particularly Medicare, Medicaid and Social Security. The mainstream media hailed this as a sign of their new maturity.

Republican leaders have already begun threatening to let the full sequester — $85 billion in across the board spending cuts from the military and domestic spending — take place on March 1. This represents over 7 percent of annual spending on the military and 5 percent on domestic governance. To achieve those cuts with half of the fiscal year already behind us will require massive lay-offs — furloughs without pay — of workers, 15 to 20 percent of food and drug inspectors, air traffic controllers, park rangers, Social Security administrators and more.

Across the board cuts means that the vital gets slashed at the same rate at the wasteful. Cuts in housing vouchers will leave millions homeless. But overseas tax dodges will remain in place. In a weak economy, already in decline in the last three months, this is worse than reckless; it is lunacy.

Democrats have succumbed to the austerity hysteria as well, if in less virulent form. Senate Majority Leader Harry Reid supports cutbacks, but wants the deep sequester cuts replaced "in short increments" with packages of spending cuts and revenues like repealing oil and gas subsidies. The president wants a "balanced" plan that combines spending cuts and revenue from loophole closings, shutting down overseas tax havens and the like. This allows a more rational policy of cutting waste and loopholes rather than essential services and military preparedness. But it still will cost jobs. More austerity is on the way.

4. The deficit hawks are delusional

Serial hostage taking is a truly inane way to run a government. What is striking, however, are the purblind delusions about deficits. We're forced to these measures, Republican Rep. Paul Ryan says, because deficits are out of control and will soon, eventually, sometime lead to America becoming Greece, with the dollar losing all value. It is a testament to the depths of his delusion that Ryan has been saying this for years, despite all evidence to the contrary.

The reality is the reverse. Ryan prides himself on his Ayn Rand devotion to free markets, but he's ignoring what the markets are saying. Out of control inflation hasn't broken out. Investors are not panicked. They are still willing to park their money in U.S. bonds for essentially no real return. Investors are saying that America isn't Greece; it's the rock of Gibraltar.

One reason is that the deficit isn't out of control. As the Congressional Budget Office reports, the annual deficit is down by 25 percent since 2009.

It is coming down faster than any time since the demobilization at the end of World War II. Our median term debt is essentially stabilized as a percent of GDP. Our long-term debt projections are completely a question of fixing our broken health care system.

The pace of the decline of annual deficits already exceeds prudent speed limits, contributing to faltering and inadequate jobs growth, leaving Americans struggling with mass unemployment, increased insecurity and declining wages. The major threat to declining deficits is an economy that stalls and goes back into recession. And that is exactly the warning that is flashing from the last quarter's decline.

Calm the austerity hysteria

The unexpected bad news from last quarter is a stark warning. Americans cannot afford the deficit delusions afflicting Washington. Republicans can only do damage if they continue to hold the economy hostage to force cuts in vital security programs like Social Security and Medicare. Democrats should reassess their austerity agenda.

We need a return to sensible governance. Repeal the sequester — sudden and deep across the board cuts are idiotic. Promise to pay the debts already incurred and stop threatening a default that would shake global finances. Fund the government while working on a budget reflecting new priorities.

Commit to growing our way out of the hole we are in. Invest in areas vital to our economy and to our people. Pay for those commitments in ways that makes sense. Put people back to work and watch the deficits and debt burden come down.

That means launching a major five-year initiative to Rebuild America — modernizing our decrepit infrastructure to make it a competitive advantage while creating jobs. Make the investments needed to provide every child with a world-class education — from universal pre-school to skilled teachers to affordable college. Invest in research and development and sustain America as the global hotbed of innovation.

Pay for these and other vital priorities by ending the war in Afghanistan and reducing our empire of bases. Crack down on overseas tax dodges. Raise taxes on millionaires and tax the income of investors at the same rate as that of workers. End the obscene subsidies to big oil, big Pharma and big Agra.

This isn't rocket science. It is common sense. Yet, at this point, it can't be heard in the bedlam of a Washington afflicted with deficit delusions and austerity hysteria.