It was a busy second day of the new fiscal year at the printing facility tucked inside a quiet business park in a shaded east Sacramento neighborhood. But unlike most days, they weren't printing thousands of checks paid by the state of California.

This time, they were printing documents that aren't worth anything. For now, at least.

Today, for only the second time since the Great Depression, the state of California sent out a whole lot of promises to pay when it can -- more than 28,000 on this first day, IOUs totaling some $53 million. The budget crisis is about to hit home for a lot of folks waiting to be paid.

The printing of IOUs this afternoon, known in government-speak as registered warrants, pretty much was the culmination of a rare day in California budget battles. This morning, the state's top financial officials met to set both the interest rate and the date of repayment for the IOUs, which -- barring a deficit deal -- will total $3.36 billion by the end of July.

That meeting of the state's Pooled Money Investment Board was itself noteworthy. The panel of Controller John Chiang, Treasurer Bill Lockyer, and Department of Finance director Michael Genest is, to say the least, obscure. And yet this morning's meeting was standing room only, even though Lockyer and Genest sent advisers in their stead... Chiang was the only top dog on hand.

Chiang and Lockyer's representative prevailed in setting the interest rate of the IOUs at 3.75% and a maturity date of October 2. Genest's representative, Tom Sheehy (whose department is actually under the direction of Governor Schwarzenegger) pushed for a lower interest rate -- 1.5% -- and a repayment date as late as June 2010.

Let's step back a moment and consider that bit of information. Because the interest rate is based on a yearly accrual, and because the IOUs are only expected to be around for three months, the interest rate that was ultimately chosen is pretty low. On a $1000 invoice owed by the state, the payee would receive an underwhelming $9.38 in interest come October.

Schwarzenegger's advisers wanted that same $1000 to be held for as long as a year... at which point it would be worth $1015 (if paid back in three months, it would be $1003.75). That's an awful big favor that thousands of private companies, local governments, and taxpayers (awaiting tax refunds) would be giving to a state that doesn't seem to be able to handle its money very well. The Schwarzenegger team said their preferred plan (again, it was rejected by the controller and treasurer) was simply a way to preserve options for the cash-strapped state.

Chiang, in comments to reporters this morning, said what many might be thinking: the IOUs and the payback deal make California look... well... lousy.

"That's a sign to Wall Street that the state is in a state of fiscal mismanagement," said Chiang. "And that clearly creates implications for further downgrades of California credit ratings, which are today the lowest rated state in America."

For now, several financial institutions seem willing to go along, which means that folks who receive one of the IOUs might just be able to deposit them and go back to their normal lives; the banks that accept IOUs will be the ones that then collect payment plus interest from the state come October. Yesterday, Bank of America agreed to take IOUs; today, Wells Fargo followed suit. But there's a catch: the two big banks only signed on until July 10, just eight days from now. Any willingness to accept IOUs issued after that is still a crapshoot.

And the banks didn't miss an opportunity to take a jab at California's pols. "We join all Californians in urging our Legislature and Governor to take the appropriate steps as soon as possible to resolve this budget crisis," Wells said in a statement.

The interest on the IOUs doesn't come cheap; Chiang's office projects $25.8 million in interest costs for July's payments by the end of 90 days (they dispute an earlier projection from the governor's budget shop of $45.5 million in interest costs).

The creation of California's version of Wimpy's Promise (which was mailed with the above mea culpa letter) came at the same time private negotiations continued under the Capitol dome on a deficit deal. And while all say they're working to resolve their differences, it's clear Democrats still believe the governor could have avoided the IOUs.

"He dropped the ball in my opinion," Assembly Speaker Karen Bass told reporters this afternoon. "His actions led to the issuance of IOUs." And she didn't stop there, accusing Schwarzenegger of being primarily interested in "fixing his legacy."

As for the governor, he told a Fresno audience today that "the only thing (legislators) did accomplish was partial solutions that lack both the necessary cuts and the long-term reforms."

Neither house is scheduled to convene over the Independence Day holiday, though talks are expected to continue. Senate President pro Tem Darrell Steinberg has let his members go home, though instructed them that if called, they need to be back in Sacramento within four hours.

Meantime, the IOUs are in the mail and are already creating an odd atmosphere. As Bloomberg first reported today, the California scrip is already showing up on sites like Craigslist... with some folks buying and selling for souvenir purposes, and some possibly offering less than face value... a deal the more desperate IOU holders may be willing to make.

The battle over California's gaping budget hole is probably going to get more intense before it ends... as just about everyone thinks someone else is to blame.

Actually, the title of the posting isn't quite true (though an homage to a great song); it appears the state budget gap grew overnight to $25.3 billion, after a series of stopgap measures were rejected by Senate Republicans and Governor Schwarzenegger.

You'll see that number reported elsewhere as $26.3 billion; but the governor's budget team is assuming a $1 billion reserve for the new fiscal year. Picky, yes, but a reserve isn't a deficit... and so we'll be calling it a $25.3 billion shortfall.

In a Capitol news conference, Schwarzenegger put forward a new set of deficit solutions totaling $4.882 billion. And tops on that list: a formal suspension this year of the public school funding guarantee, Proposition 98. Prop 98 has really only been suspended once before in its 20 year history (though twice if you count changes following the '89 Loma Prieta earthquake). And that one time came during Schwarzenegger's first days as governor in 2004, a move at the time he insisted (after a question by, well, me) was a "rebasing" of Prop 98.

That's because suspending Prop 98 is often controversial; it means the state can spend less on public schools than the voters dictated by ratifying the ballot measure in 1988.

In the 2009 version, Schwarzenegger again attempted to present the new world order for California public schools as not so bad. "This is consistent with what I said when I promoted and campaigned for Proposition 1B," said Schwarzenegger. He's referring not only to the $9 billion in supplemental funding that Prop 1B would have provided had it not been defeated, but the reemergence of that obligation to schools that exists now that the 2008-2009 spending reductions have evaporated. (Sort of. Prop 1B generally referenced the same money now obligated to schools, plus or minus a bit. Again, this is a 'how Prop 98 works' discussion for another time.)

Good thing for schools? Bad for everyone else? The governor's take:

Call that spin or just eternal Schwarzenegger optimism, but the governor's assessment of education funding was the only thing upbeat on this day after the ugly end to the fiscal year that just passed by.

Schwarzenegger also declared a formal fiscal emergency, vowed to veto any bill on his desk that wasn't budget related (and legislators scrambled today to yank some back that were pending), and added a third furlough day for state workers every month.

The furlough day was one of the final straws for the small but vocal crowd of workers who rallied outside the state Capitol today, chanting, "Enough is enough!" It's projected to save the state $425 million this fiscal year, and when combined with the existing two furlough days amounts to close to a 15% monthly cut in pay. The governor's advisers say the furloughs will now largely revert back to fixed days off (Fridays), rather than the 'self-directed' policy that has let workers take them at their own convenience.

Meantime, Democratic legislative leaders are moving to focus on the deficit issue, too. Senate President pro Tem Darrell Steinberg has ordered the postponement of all policy committee hearings indefinitely -- thus stopping work on all issues that can't be tied back to resolving the deficit crisis.

Steinberg was a study in frustration last night. The Sacramento Democrat universally known as a Mr. Nice Guy, Steinberg appeared to find himself stuck negotiating for a deal that couldn't be sealed. His comments after it all fell apart depicted a frustration the pro Tem rarely shows in public.

From here, the immediate impacts will likely dominate the headlines -- especially the all-but-certain issuance of IOUs for some state invoices beginning tomorrow. But in many state budget negotiations, the longer a painful deal sits out there the more it begins to unravel. Assuming this one was ever bound together, that's going to make for some more long days and nights as FY 2009-2010 begins.

At 11:57 p.m., Senate President pro Tem Darrell Steinberg shut things down. And that was that.

Of course, now the sobering news: the $3.3 billion in missed savings is now being estimated as adding $8 billion in problems for the state budget. For that, you only have to look to the voter-approved Proposition 98, whose complicated formulas are based on spending in the previous fiscal year. Because that school spending wasn't reduced by $3.3 billion, it comes out on the other side as much more.

(There were varying accounts by the end of the drama as to the ballooned size of the missed savings; the above came from comments on the floor by Sen. Denise Ducheny, chair of the upper house's budget committee. Some estimates call it a $7 billion problem. And then another question: does that mean the deficit is now... $28 billion? Too much math.)

Credit Governor Schwarzenegger with holding firm on his pledge to reject anything that wasn't a $24 billion fix, a stance that might have helped keep any GOP senators from grabbing the savings off the table before they disappeared at midnight. Remember that Republicans in the Assembly did just that last week.

"I can guarantee you, as much as I stand here right now," the Guv said to reporters earlier in the day. "The $3 billion partial solution will be vetoed without any doubt."

Where things go now... anybody's guess. The issuing of IOUs by the end of Thursday now seems a pretty likely scenario, barring some Hail Mary thrown by legislators later today. A spokesperson for Controller John Chiang said if the IOUs are necessary, 28.742 would be issued on day one... totaling $53.3 million, and sent largely in lieu of tax refunds.

Stay tuned.

In the aggregate, the 'Plan B' proposal adds up to $23.7 billion, compared to Schwarzenegger's $23.9 billion May revise and the Democratic legislative plan of $23.4 billion.

The governor would agree to drop plans for eliminating welfare assistance, health care for poor children, and financial aid for college students. He would not, however, agree to any Democratic tax increases -- including the proposed $15 car tax to pay for state parks. And his advisers say he maintains his insistence on both a 5% pay cut and a reduction in health care benefits for for state workers.

The governor would go back to his planned suspension of Proposition 1A local government revenues (worth almost $2 billion), and would agree to a modified version of Democratic plans to shift state worker paychecks by one day, thus saving almost $1 billion.

Aides say he would abandon his controversial plan to close state parks, and would find the money for parks operations elsewhere (not in the above-mentioned vehicle fee).

In the Healthy Families program providing health care for kids from low-income families, Schwarzenegger would cut funding by $95 million more than the Dems, and would limit eligibility to those whose families earn 200% of the federal poverty level (about $44,000 for a family of four).

On the issue of CalGrants -- the student financial aid program he's called for elminating -- Schwarzenegger aides say the guv would make a number of changes, including a freezing of income eligibility levels and detaching current allowances of higher grants for higher tuition (thus freezing current levels).

These are just some of the changes; aides say Democratic leaders are aware of these proposals, but have not seen the same charts reporters were shown this afternoon. And they say it shouldn't be characterized as a 'counteroffer' on the part of the governor; Schwarzenegger spokesman Aaron McLear said it's simply "another way" to get to the governor's bottom line.

The 'Plan B' proposal aside, the governor's staff also discussed the tough road ahead should the $3.3 billion in current year savings be forfeited, due to lack of a deal by midnight tomorrow. They believe that the missed deadline could also create an additional obligation to public schools in 2009-10 of some $3 billion (known as a "maintenance factor" in Proposition 98 jargon). And furthermore, only about $1 billion of the $3.3 billion in 2009-09 savings could come from education (due to federal stimulus law)... the rest would have to come from somewhere else.

But should the current budget deficit impasse drag on beyond midnight Wednesday, it appears that's how much more money will need to be found to satisfy anyone who believes in solving what we used to call the whole enchilada.

And if the issue has been somewhat obscured by weekend sniping over majority-vote tax increases and media coverage of systemic reform, it ought not to be... because it's likely to be the first real test of how bad things will get.

In a nutshell: the deficit solutions pitched by both Governor Schwarzenegger and Democratic legislators rely on a spending reduction of about $3.3 billion in the 2008-2009 fiscal year that ends on June 30.

That's tomorrow at midnight. Once the new fiscal year begins, those savings are effectively gone.

$3 billion of those savings would come from K-12 and higher education. They are not popular spending cutbacks in education circles, but reflect the larger 'all options are bad' narrative that you've heard in all circles for the past several weeks. The final $300 million or so of current year savings come from a plan to transfer money away from local redevlopment agencies.

Budget staffers say it matters which budget year to which these spending reductions are attributed (2008-09 vs. 2009-10) -- in large part because additional cutbacks in 2009-10 could complicate the already delicate issue of eligibility for federal stimulus dollars.

Immediate savings are important for another reason: they provide some breathing room for the cash-depleted state coffers and might lower or eliminate the need for Controller John Chiang to issue IOUs by week's end.

This issue will again be the focus of legislative debate this afternoon. The state Senate is expected to take up a three bill package that GOP senators and the governor both rejected last week, after Assembly Republicans agreed to provide enough votes in the lower house to approve the stopgap measure. The bills actually are valued at $5 billion in savings, and include additional proposals.

All of this elevates the importance of the fiscal year's passing -- an annual marker in budget debates that this year has seemed less relevant (contrary to some news reports, this summer's debate isn't over a new budget but rather a revised budget... the new budget was enacted in February).

So will lawmakers find an omnibus compromise by Wednesday and be able to take advantage of the $3.3 billion in current-year savings? Will they remain deadlocked and then have to find other places to cut the budget? Or will Schwarzenegger and other Republicans agree to a stopgap plan of action?

If the governor is considering the final scenario... he sure didn't let on to it in comments made today to reporters; in fact, just the opposite.

"I will not sign a budget that is a piecemeal operation," Schwarzenegger said today. "That doesn't do it."

The governor has put a few addtional budget proposals on the table since last week, but those don't seem to have bridged the gap with Democrats. And so the clock keeps ticking... and all sides wonder where lawmakers would find another $3 billion if the clock runs out on the solutions on the table.

But that's where things stand as of this morning, and this week's Capital Notes Podcast examines the week so far, from stalled spending cuts to the specter of IOUs and beyond.

Capitol Weekly's Anthony York and I also take a look at the big news about the mayor who's not going to run for governor in 2010.

(And yes, the podcast was recorded late Thursday... so beware the shelf life should some budget breakthrough happen from here on out.)

Of course, that's not to say that some parts of today's budget news weren't unexpected. And few would venture a guess as to what happens next... though indications are the Legislature will be spending the final weekend of June in session.

For a formal look at today's events, dial in to The California Report tomorrow morning. In the meantime...

Cut More: It's not surprising that Republicans want more spending cuts, but how much more... and from where... will be one of the threads worth following in the next few days. In comments to reporters after the failed floor vote, Senate GOP Leader Dennis Hollingsworth said that his caucus wanted substantially more spending cuts... up from the Democrats' $11 billion to as much as $19 billion. Asked what those were, Hollingsworth referenced actions rejected by the budget conference committee and ideas floated a few weeks ago by the Legislative Analyst's Office. But what another major reduction in spending would look like... and who it would impact... is, for now, unclear.

You Dropped A (IOU) Bomb On Me, Baby: Controller John Chiang wins the award for stealing thunder today, with his announcement during the budget floor debate that he could be forced to issue IOUs as soon as next Thursday. While that news created some extra smoke inside the Capitol, it didn't generate much heat. Still, it was enough to merit mention by Senate President pro Tem Darrell Steinberg in his closing statement, and by Republicans in lamenting the state's creep towards fiscal meltdown. The state is scheduled to write checks totaling $14.26 billion in July; what's most interesting is how little of that can be stopped. The controller's office says only $3.36 billion of that amount can be delayed with IOUs. And sources say even that could be shrunk under scenarios being examined for delaying some of the mandatory July payments for public schools.

There's going to be an awful lot written about the IOUs in the days to come, but a couple of factoids for now: the state has only issued them twice -- in 1982 and 1992. The 1982 experience hardly even counts, as they were written and redeemed on the very same day. In 1992, the state issued just shy of $4 billion in IOUs (registered warrants, to be exact) in July and redeemed them in September. And finally: the only silver lining for those who can hang on to the IOUs for three months without getting paid (Chiang says the plan is to redeem them in October) is that they earn interest, unlike February's deferred payments. The official rate will be set next week, but the conventional wisdom is somewhere around 5%.

Solution Size: Given things are currently stuck in a squabble about how much of a solution is needed -- $24 billion, $19.5 billion, $23 billion, etc. -- the real question is what will Wall Street investors think? And for that, lawmakers have been saying they've put their trust in the estimates offered by Chiang and Treasurer Bill Lockyer. I've asked both fiscal officials in the last 24 hours about what size of a deficit solution is needed. Both believe the bigger the better, but after that... who knows. Lockyer politely sidestepped the politically sensitive question (during an interview for yesterday's story about California's impact on the national economy). Chiang made it clear that a sub-$24 billion deficit package wasn't abhorrent, but said it wasn't preferable. "Short of (a $24 billion solution)," he said, "there had better be cash in the state's treasury." Or consider this comment: "As these bills come due, there had better be cash to pay that."

By the way, one more tidbit from my interview with the controller: he said that Wall Street types are already casting some skeptical eyes on parts of the discussed deficit package. Like what? Chiang mentioned Governor Schwarzenegger's plan to sell off a portion of the State Compensation Insurance Fund for $1 billion, a plan Democrats have embraced.

What Next? That's the big question. Assembly Speaker Karen Bass told reporters this afternoon it's not out of the question that she'll put the same $11 billion cuts bill (dubbed "Budget Bill Junior" in the Capitol) up for a vote again... even though it didn't garner all of the Democratic votes in either house. Or perhaps something else, said Bass. And for those of you with weekend plans (umm, that's us in the press corps): cancel them.

Few expect that today's debate and votes in the Legislature will produce a final resolution to California's historic fiscal crisis.

But by day's end, there will hopefully be a better sense of where we're headed... and when. Can lawmakers strike a deal before the state runs out of money in less than five weeks time?

The Assembly and Senate are scheduled to convene this morning to consider a package of bills, largely crafted by the Democratic majority, aimed at erasing $23.3 billion in budget red ink. Some points worth pondering as the action gets underway:

Why It All Comes Down to $3 Billion: This theory focuses on the fact that the Democratic plan, stripped of its controversial tax increases, is valued at about $21.5 billion... while Governor Schwarzenegger's deficit package is worth about $24.3 billion. Simple math whizzes, therefore, will conclude that the tax increases pitched by the Dems are essentially a replacement for Schwarzenegger's planned elimination of social services programs. "I'd rather have $21.5 billion of solutions than zero," said Senate President pro Tem Darrell Steinberg yesterday. To which the governor's press secretary, Aaron McLear, quickly replied: "We will not support a fix that does not add up to $24 billion."

Why It's Not Just About the $3 Billion: There are other elements of the budget debate that strain the "$21.5 billion vs. $24.3 billion" narrative. For starters, there's the Democratic plan to require anyone who hires an independent contractor to withhold 3% of the payment for tax purposes. Those contractors ultimately pay the money to the state as it is, but this would "accelerate" that payment, to the tune of an extra $2 billion in the budget year. The Guv and GOP legislators have suggested it's a no-go. Ditto for the Dem idea of a "one day/$1.2 billion paycheck shift." Add the value of those two plans to the dispute over taxes-versus-cuts mentioned above and you end up with a dollar gap that's much bigger than $3 billion. And that doesn't even include disagreements over deeper cuts to state worker pay, funding for state parks, etc.

Should We Just Forget About The Taxes Already? It's one thing when pundits write off Democratic plans for atax increase; it's another when the leader of the upper house does so. "We're probably not going to get them," Senate pro Tem Steinberg said about the taxes in his Q&A with reporters Tuesday. And making the point even more clear, Steinberg said that Dems will not link the tax hike to the spending cuts... thus avoiding an all-or-nothing squeeze play. "They (taxes) are not joined to the rest of the package," he said.

Taxes May Not Be Linked, But... The single biggest chunk of spending reductions are apparently now linked to a proposal that costs the state money. Call this one the Proposition 1B redux; you'll remember that the defeated May 19 proposal would have guaranteed an extra $9 billion for public schools and resolved a legal dispute about how California's education guarantee works. Now it appears that the propsoal is back; at least one of the budget "trailer bills" debated today (which contain lots of statutory details for enacting budget solutions) will contain language related to both the K-14 spending reductions and the disputed supplemental funding. Yesterday, The Sacramento Bee opined that the proposal would "tie the Legislature's hands" in the years to come. As you can see, procedural issues matter... because the only way a legislator can vote to reduce school spending is to also vote in favor of additional school spending.

What Will Republicans Do? GOP legislators have generally panned the Democratic deficit package while aligning themselces with the governor's call for a $24 billion solution. But when Democrats put a bill up to reduce state spending by billions of dollars... even if it's not as much as the GOP wants... will they vote no? "(The) budget vote is a political drill and nothing more," says Assembly GOP caucus spokesperson Jennifer Gibbons. (Capitolspeak: a "political drill" is when you know the outcome, and you do it just to make a point. It appears Republicans aren't willing to engage in any scenarios other than the obvious.)

What Will Democrats Do? And it's not that much clearer what happens if the majority party finds itself without the deal it wants today. Senate pro Tem Steinberg seemed to indicate Tuesday that, if need be, the deficit package (minus the tax hike) could be sent to Schwarzenegger without Republican votes. Even the revenue accelerations and fees could apparently be approved on a majority vote by convening a special session. Aside from the political ramifications, the problem with that path is that many of the deficit solutions can only take effect immediately through an urgency vote -- which requires a supermajority. Budget staffers were apparently still crunching numbers as of Monday on how much savings would be lost were the spending cuts to take effect in 90 days -- the legal lag time for proposals passed by a simple (read: Democrats-only) majority.

But such power can also work in reverse, say economists. And now, there is speculation that whatever ugly deficit deal state lawmakers strike, its necessary slashing of public services could either slow, or stop, the economic recovery of the entire nation.

That possibility was the focus of my story this morning on The California Report. And, if anything, it should serve as a word of warning to leaders in Washington, DC, who seem reluctant to do very much to help California out of its current plight.

Radio Story Audio

One prominent critic of that hands-off stance is James Galbraith, a nationally known economist and professor at the University of Texas. "The cuts that California is being forced to make," he says, "they’re deeply counterproductive to the recovery of the national economy."

Galbraith acknowledges that some of the deficit problems of California government are of its own making, but says that much of the current crisis is global in nature. And furthermore, he wonders why such a powerful economic engine for the nation is getting the cold shoulder, while less-deserving entities did not.

"I would have to ask," says Galbraith, "why didn’t they say that about Bank of America? Why didn’t they say that about Citigroup? What’s so special about these big banks -- which we, in fact, have more of than we need -- that doesn't apply to the public services being provided to the citizens of the United States who happen to live in California?"

Last week, the administration of President Barack Obama squelched any such talk for the time being. "This budgetary problem," said press secretary Robert Gibbs, "is one that they're going to have to solve."

To be fair, though, state leaders haven't been asking for money... an pretty important fact that seems to have been missed by the national press. Particularly baffling was last week's story in The Washington Post, which raised the spectre of California begging for a bailout.

What California wanted was not money, but rather a loan guarantee. Such a 'backing' of the state's debt, first floated last month by Treasurer Bill Lockyer, would have helped the state get a better deal on its need for as much as $10 billion in cash flow borrowing in July.

Without that guarantee, says Lockyer, "you wind up kind of 'bare' as they say in the market, and you pay more to get that borrowing done."

Lockyer doesn't have an estimate on what the extra cost will be, but guesses it will be in the hundreds of millions of dollars... a cost paid with the same dollars that otherwise would go to vital state services.

Which begs the question: why can't Callifornia get anyone to listen? "It's hard to see how the country recovers if California does not," says U.S. Rep. Zoe Lofgren (D-San Jose). Lofgren says she thinks congressional authorization of loan guarantees for any state will happen. But no one thinks it'll happen in time for California, which needs to go to market -- assuming a budget deficit deal is agreed to in the state Capitol -- early next month.

Lofgren says she's particularly troubled that the national stimulus and recovery programs... which are expected to benefit California by as much as $80 billion... could be drained of their help by the cuts needed to balance the state budget. "It is contrary to the efforts that we're making," she says.

Still, there's not much chance that legislators and Governor Schwarzenegger can avoid painful cuts. And there's some sense out there in the rest of the nation that California should just take its lumps and zip it. One great example: the June 1 editorial from the Mobile (AL) Press-Register, entitled "Cut California Loose." An excerpt:

Now Gov. Schwarzenegger and other state officials are pleading with President Obama to save Cal-lee-FORN-ya, as the governor calls it. They want the federal government to guarantee the state's dicey loans.

If the president and Congress go along with this, expect every profligate state to go to Washington, hat in hand, asking for federal help. With the federal deficit soaring toward $2 trillion and President Obama pushing for at least $700 billion more in deficit spending, the added cost of bailing out irresponsible politicians all over the country could be the tipping point for our debt-crazed nation.

Treasurer Lockyer says he heard a similar sentiment recently from a big investor from what he would only call a "southern" state, and replied thusly: "Do you realize that we've been subsidizing your state? Because you get more back from the federal government than you send to them [in tax dollars], we get less back from the federal government than we send [in tax dollars] to D.C."

Whether the investor was convinced is another story. Perhaps he should be reminded of the old adage, which has proved true many times before, that as California goes, so goes the nation.