July 1 (Bloomberg) -- California Governor Arnold Schwarzenegger said he will shut down government offices the first three Fridays of every month and declared a fiscal emergency forcing lawmakers into a special session to tackle the state’s growing deficit.

The Legislature’s failure to fix the budget before the fiscal year began today pushed the size of the spending gap to more than $26 billion from $24 billion, Schwarzenegger said. Because of a recession-driven drop in revenue, California is set tomorrow to begin paying some of its bills with IOUs to avoid running out of cash.

“Every day we wait, the problem is getting bigger, the deficit is getting bigger, because right now we are spending money that we don’t have,” Schwarzenegger told reporters at a Sacramento news conference.

Schwarzenegger and the Democrats who control the Legislature are at an impasse over how to eliminate a budget gap that emerged less than five months after the passage of tax increases and spending cuts intended to shore up the state’s finances. California, the most-populous U.S. state, has been battered by a recession that caused its revenue collections to tumble by $13 billion to $73 billion in the 11 months through May from a year earlier, according to the controller’s office.

The Republican governor, who has sought spending cuts that would eliminate welfare programs and push nearly 1 million low- income children out of government health insurance, ruled out another round of tax increases, and sought measures to crack down on fraudulent welfare claims and other government waste.

Terminating Government

Democrats want fewer reductions and some tax increases to make up the difference.

“The governor has said we can’t kick the can down the road, but instead he wants to kick California in the stomach,” said Assemblyman Charles Calderon, a Democrat from Montebello, near Los Angeles.

“When the people of California elected ‘The Terminator’ as governor, they didn’t know that the state would be his latest victim,” he said, referring to one of Schwarzenegger’s most famous roles during his prior career as a Hollywood actor.

The governor’s order to close much of the state government for three days a month will force some 200,000 employees to take another unpaid day off. The shutdown is set to begin on July 10 and run through the end of the fiscal year, in June 2010, Schwarzenegger’s office said in a statement. Prisons, hospitals, highway patrol offices and fire stations won’t be closed.

Cash Running Out

Without a revised budget in place, California’s top finance officials say the state can’t secure a loan it needs to pay bills until the bulk of its tax collections arrive later in the budget year. Controller John Chiang has said such a borrowing would be too costly, and potentially impossible, without assurances that investors will be repaid.

With its cash reserves dwindling, Chiang, the elected Democrat who pays California’s bills, is set to begin issuing IOUs, instead of cash, for $3.4 billion of the $14.3 billion of payments the state is set to distribute in July. The promissory notes will be used to pay welfare benefits, businesses that provide services to the state and student aid, according to the controller’s office.

“It’s important for everyone to recognize that we are running out of cash,” Schwarzenegger said. “It is extremely important that the Legislature looks at this seriously.”

Questions on IOUs

It will be only the second time since the Great Depression that the state has been forced to issue such IOUs, and some doubt the authority of the state to issue the notes.

Schwarzenegger’s budget office said it is unclear whether the people who get the IOUs would be given preference over bondholders when they need to be repaid in October, should money still be scarce. It is sponsoring a bill to clarify the matter. He said he will also get in touch with banks to persuade them to accept the notes as deposits from customers.

The worsening fiscal crisis has rattled Wall Street, even though officials including Schwarzenegger have repeatedly said that the state won’t default on its bonds. Fitch Ratings on June 25 lowered California’s credit rating to A- from A. The state’s $59 billion of debt is rated A2 by Moody’s Investors Service, five steps above non-investment grade, and a comparable A by Standard & Poor’s. Both companies have warned of reductions.

Credit Affirmation

“We recognize that downward pressure on the state’s ratings is growing,” Standard & Poor’s said today in affirming its rating on the state’s debt. “However, our rating opinion also reflects the magnitude of the state’s economic base and that flatter or just marginal improvement in the economy may quickly translate to additional revenues.”

A California bond maturing in 2037 traded for as little as 82.86 cents on the dollar yesterday to yield 6.31 percent. The price is down from as much as 97.25 cents on May 12.

Schwarzenegger expressed hope that he may be able to reach a deal with the Democratic leaders in the Legislature, as he did after a record-long budget fight in February.

“I think we can get together,” he said. “We have done it in the past.”

To contact the reporters on this story: William Selway in San Francisco at wselway@bloomberg.net; Michael B. Marois in Sacramento at mmarois@bloomberg.net.

Last Updated: July 1, 2009 18:39 EDT