Sinclair Stewart

New York - Globe and Mail Update Last updated on Friday, Jul. 03, 2009 03:32AM EDT

Five years ago, when he took the stage at the Republican National Convention in New York, Arnold Schwarzenegger took a moment to chastise the pessimists who dared question America’s financial hegemony.

"Don’t be economic girlie men" the California Governor scolded, invoking his strongman past to peals of laughter.

But no one is laughing now, least of all Mr. Schwarzenegger.

In yet another humiliating setback, the cash-strapped state has declared a fiscal emergency, and yesterday began issuing IOUs to pay more than $3.4-billion (U.S.) worth of bills.

Most of the money will be used for tax refunds, student aid, and small businesses that provide goods and services to the government.

This was a desperate move by a state that has all but run out of options, illustrating not merely the severity of its financial condition but also the bungling partisanship of its political system.

Democrats and Republicans have been bickering for months over how to close a budget deficit that swelled to $26.3-billion on Wednesday, the first day of California’s fiscal year.

But with the two parties unwilling to bend toward compromise, the state had no choice but to issue these promissory notes - formally called registered warrants - for the first time since 1992, and only the second time since the Great Depression.

California was the epicentre of the U.S. subprime mortgage industry, and the resultant collapse of the housing market, where prices are down more than 40 per cent from their peak, has slashed the revenue it collects from property taxes. The state’s credit rating is now the lowest in the country, and could fall to junk status soon, while unemployment has risen to 11.5 per cent.

If lawmakers aren’t able to cast aside their differences and clean up this financial mess, the consequences could be grave - not just for Californians, but for the entire country.

The state’s annual economic output is more than $1.8-trillion (U.S.): That’s enough to make it the eighth-largest economy in the world, ahead of both Spain and Canada, and to create serious ripple effects throughout the United States.

As part of the fiscal emergency, more than 230,000 government workers will have to take a third unpaid day off each month, while public universities will see their funding trimmed. Republicans, who are unwilling to raise taxes, have proposed releasing prisoners early, closing state parks and making further cuts to social programs for the poor. The Democrats have countered with a plan that would reduce services and increase levies on cigarettes and oil, among other remedies.

California’s flakier side emerged during the crisis this week when the legislature was deciding whether to approve a bill that would make it illegal to amputate the tails of cows.

Mr. Schwarzenegger, who is fond of communicating through Twitter, complained in a tweet that "Instead of working on budget, the Legislature is about to debate whether cows can keep their tails while we’re in a fiscal crisis." He also had a member of his staff videotape the debate and post it on YouTube - further inflaming tensions between the two parties.

The government was scheduled to send out its first tranche of IOUs yesterday, representing about $53.3-million in payments. Up to $3.4-billion will be distributed this way in the coming weeks if the state legislature isn’t able to hammer out a deal to reduce the deficit.

California will pay a 3.75-per-cent interest rate on the IOUs, which mature on Oct. 2, although Bank of America, Wells Fargo & Co., and JPMorgan Chase & Co. have each said they would redeem the notes up to July 10.

The state has a $2.8-billion cash shortage this month, and that is expected to swell to $6.5-billion in September, said California Controller John Chiang.

"Unfortunately, the state’s inability to balance its chequebook will now mean short-changing taxpayers, local governments and small businesses," he said. "IOUs are an indication that the state cannot pay its bills on a timely basis. When you have fiscal mismanagement it could lead to further downgrades."

Arizona, Illinois and Pennsylvania also face political gridlock in dealing with their growing deficits, although the size of their shortfalls remains much smaller than that of California.

Mr. Schwarzenegger, who as an actor was known as much for his offbeat wisecracks as his muscled torso, hasn’t lost his sense of humour - much less his willingness to inject bizarre commentary in the midst of serious political issues.

After visiting Fresno Thursday afternoon to discuss the budget situation with residents, he took a moment to post his thoughts on Twitter. "Fresno protests have good lines," he wrote. "Esp. the guy asking me 2 sign Terminator 2 & budget. But saying he loved me in Red Sonja - below the belt."