The important thing to realize was that Germany was in a state of collapse in November 1918 despite being territorially intact. Civilian hardship coupled with the failures of the 1918 offensives had sapped much of the will to fight among the population. This loss of morale was not just limited to civilians; the German military was itself in a slow-motion collapse of sorts as indiscipline and cynicism became more apparent. The most salient sign of this was the Kiel mutiny of the fleet in which the sailors of the navy, with some justification, mutinied when facing the prospect of going into battle on a death-ride against the superior Anglo-American fleet. The army's internal cohesion was greater than the largely port-bound navy, but there were signs too that support for the war was fraying in the trenches. The historian Wilhelm Diest has claimed that the Heer's soldiers conducted a "covert military strike" as upwards of one million troops evaded duty on the Western front in the summer of 1918 by feigning illness, disappearing to the rear, or any of the other myriad ways to avoid combat. While there were a number of hotheads in OHL calling for a death ride to the very end, a number of sober officers recognized the war was lost. Retreating to the German interior may have been feasible, but it would have only been staving off the inevitable.

Added to the dire military situation were also domestic factors. The Kaiserreich was an authoritarian state that kept a number of democratic political parties in check. Some of these parties like the Catholic Centre worked with the state, but others like the SPD had a more antagonistic relationship with the state prior to 1914. The advent of war had forced a type of political truce, the Burgfrieden, in which Germany's political parties made common cause with the government for the war effort. But this truce only masked over the antagonisms that had festered between the party chiefs and the imperial state that had been there since Bismarck. The Kaiser's lost war forced these political parties to try and take over the political situation in 1918, especially after the military chiefs had informed their civilian counterparts that the war was now unwinnable. Seeking an armistice was the only viable political situation for these political parties.

But the what would soon become the dominant political parties under Weimar were far from triumphant in November 1918. Party newspapers tended to announce the creation of the republic in a very somber tone and internal discussions among the Reichstag's leaders like Ebert were equally pessimistic. Not only had they inherited a collapsing civilian economy and lost war situation, but also the threat of a Bolshevik-style revolution. The Kiel mutineers and other military mutinies did hoist up the red flag of revolution and patterned themselves after the events that had transpired in Russia the year before. The SPD had split during the latter half of the war between a more establishment SPD, which favored working within the parliamentary system, and the USPD whose partisans favored a more revolutionary solution to Germany's social question. There were other splinter groups inspired by Lenin's example, and there were also some far right movements that were determined to extinguish Bolshevism by violence. This was a fluctuating situation (and the above is only a sketch of a complex historical picture) but the political inheritors of the Kaiser did face the prospect of a domestic civil war. Removing the war as an issue from this contentious politics was a way to stabilize the domestic situation. Peace would denude the USPD and the like of a powerful propaganda tool while an armistice would allow the interim government to retain control over its military and demobilize it in a structured manner.

So keeping on fighting, even defensively, was not really a viable option in 1918. The civilian economy was in shambles and there was little stomach among the wider civilian population to continue the war. There was a widespread recognition among the military that the war was lost and there were all sorts of signs that asking them to continue fighting would have resulted in mutinies similar to the Kiel one. Moreover, the exact terms of Versailles were unknown in November 1918. Although the Treaty was nowhere near as harsh as German right-wing nationalists would hold in Weimar (or even contemporary popular memory), there was a hope among the interim government that the Treaty that followed the armistice would be more lenient. But by 1919, rejecting the Treaty would have been impossible. There was no German military left that could have fought off the Entente and resuming the war would have sharpened domestic conflicts which were already acute in 1919. There just was no option for Ebert and company to back out of the Treaty once they had committed to it.

Exactly how bad was the German economy at this point and why couldn't they just go on the defensive like they did with the USSR in WW2?

What do you mean "why couldn't they just go on the defensive like in WW2?". Germany was on the defensive since the allied counter-attack following the second battle of Marne in August of 1918. The reality was that Germany was no longer able to continue the war.

There is no single reason for why that was so, rather it is a combination of factors. Industrial output had dropped to pre-1913 levels as a result of shortages of... everything. Food. Workers. Materials. Power. Fuel. German industry was running out of everything.

Added to this the Balkan front was collapsing and Germany certainly didn't have anything with which to help support the collapsing Austo-Hungarian empire.

The Germany army did go on the defensive, gradually retreating and attempting to shorten its line in the west but this was just not enough. Morale was low, losses in the first half of 1918 were hard to replace, supplies were running low. Even on the defensive the allies consistently broke through again and again in what is known as the 100 days offensive.

Also it's not like the german defensive against the USSR in WW2 worked out great.

Versailles was such an unfavorable treaty you'd think they'd have to reach Berlin for them to accept it, so why didn't they just bleed them out of manpower?

Because the germans were the ones who were bleeding and very badly. The sense was, and probably rightly so, that Germany was facing an imminent total collapse.