I think setting the front page to a static page is what's causing the problem - logically a static page wouldn't have page 2 / 3 etc even though this is a blog template page.
Personally, I'd change the setting back to "latest posts" i.e. use the theme template files according to the Template Hierarchy - if you look at this image you'll see that home.php is called before index.php for the homepage: http://codex.wordpress.org/images/1/18/Template_Hierarchy.png
Duplicate template_blog.php, rename it to home.php and remove this code from the top of the file:
Template Name: Blog
The blog template should now load as the homepage. If you get any layout problems, open up header.php and change this:
<?php $body_id = is_front_page() ? 'frontpage' : 'subpage'; ?>
<body id="<?php echo $body_id; ?>">
as every page (excluding the index.php home template) uses this id for the CSS styling.
Let me know how you get on.