Jan. 15 (Bloomberg) -- Governor Arnold Schwarzenegger said California has been so “incapacitated” by a fiscal crisis that threatens to leave it unable to pay bills within weeks that the only issue he and lawmakers must consider is how to fix it.

Schwarzenegger, in his State of the State address, said he is withholding all his policy proposals on issues including health care, education and infrastructure until the financial problems are dealt with. The governor also said he and lawmakers should go without pay for every day they fail to enact a budget past its due date.

The national recession, housing-market collapse and tumbling stock prices have torn a $42 billion hole in the state’s budget, the largest shortfall in its history. Political paralysis over how to fix it has left California out of money and preparing to issue IOUs for only the second time since the Great Depression. Officials say Wall Street’s credit crisis means the governor can’t borrow the billions needed to avoid the cash shortage.

“I will not give the traditional State of the State address today, because the reality is that our state is incapacitated until we resolve the budget crisis,” said Schwarzenegger, a 61-year-old Republican. “The truth is that California is in a state of emergency. Addressing this emergency is the first and greatest thing we must do for the people. The $42 billion deficit is a rock upon our chest and we cannot breathe until we get it off.”

Cash Shortage

The deficit and cash shortage developed rapidly after Schwarzenegger signed the current year’s budget in September. Since then, he’s called lawmakers into three special sessions and twice declared fiscal emergencies. On Jan. 7, he vetoed the only plan that has reached his desk from those special sessions.

Schwarzenegger’s fellow Republicans have blocked his proposal to raise taxes, which can’t be done without a two- thirds vote. Democrats, who control both chambers of the Legislature, have balked at deep spending cuts and proposals to ease environmental regulations and labor rules.

Last month, Schwarzenegger proposed a mix of spending cuts, tax increases and borrowing, as well as an economic stimulus package, efforts to curb home foreclosures and streamlined government operations.

State finance officials are preparing to withhold payments to thousands of vendors and say they will likely have to issue IOUs to people who are expecting tax refunds.

Saving Money

To conserve cash, Schwarzenegger has ordered state offices shut for two days a month and all workers to take two days of unpaid leave each month. The impasse forced a state panel on Dec. 18 to halt funding for $3.8 billion of construction on schools, roads and other public works, a decision officials said might cost tens of thousands of jobs.

“So now the bulldozers are silent. The nail guns are still. The cement trucks are parked,” Schwarzenegger said. “This disruption has stopped work on levees, schools, roads, everything. It has thrown thousands and thousands of people out of work at a time when our unemployment rate is rising.”

California, the biggest borrower in the municipal market, shares with Louisiana the lowest credit ratings among the states because of perennial fiscal shortfalls and legislative gridlock. It is rated A+ by Standard & Poor’s and Fitch Ratings, the fifth-highest grade, and an equivalent A1 at Moody’s Investors Service.

The governor has been holed up in marathon meetings with senior lawmakers all week, trying to come to an agreement. He called the talks “serious and good faith negotiations.”

Pay Day

Nevertheless, Schwarzenegger said lawmakers and governors shouldn’t be paid if they fail to pass a budget on time. While the state’s constitution requires lawmakers to send the governor a budget by June 15 and the governor to sign it by July 1, those deadlines have been met only four times in the last 20 years.

“I mean, if you call a taxi and the taxi doesn’t come, you don’t pay the driver,” Schwarzenegger said. “If the people’s work is not getting done, the people’s representatives should not get paid either. That is common sense in the real world.”

Schwarzenegger, a multimillionaire, has declined his $212,179 a year salary since he was elected. Lawmakers each make at least $116,208 a year plus $162 per day per diem; legislative leaders make more depending upon their position. At least one lawmaker bristled at Schwarzenegger’s suggestion that he and his colleagues forgo pay.

‘Perplexed’ at Governor

“We’re all perplexed as to what the governor has given up as a result of the budget situation the state faces,” said Senator Dean Florez, a Fresno Democrat. “It’s really the luxury of the super-wealthy to ask others to give up their pay.”

Bonds due in 10 years yield about 53 basis points, or 0.53 percentage point, more than general obligation bonds rated A+, the most since early 2004, according Bloomberg municipal bond yield indexes.

California general-obligation bonds maturing in 2038, with a stated interest rate of 5.25 percent, traded at 77 cents on the dollar to yield 7.12 percent on Dec. 26, according to the Municipal Securities Rulemaking Board. As the overall tax-exempt market rebounded this month, they were priced to yield 5.26 percent yesterday.

To contact the reporter on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net.

Last Updated: January 15, 2009 14:55 EST