The State of California will run out of money within two months, forcing Governor Arnold Schwarzenegger to start settling bills and paying employees by issuing "IOU" notes, his chief financial officer has revealed.

John Chiang, the state controller, admitted on Monday that a spiralling budget crisis, which has left California spending billions of dollars more each month than it can raise in taxes, will see his coffers run dry some time in mid-February.

At present, Mr Schwarzenegger's administration is spending $11bn a year more than its total income. The figure is now rising exponentially and has been forecast to hit $42bn (£29bn) by 2010.

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Unless taxes can be raised, or spending reined in, millions of public-sector employees and private contractors face having their salaries paid in "registered warrants," a piece of paper which the Governor will promise to exchange for cash as soon as he is able.

The effective bankruptcy of an entire state is unprecedented in American history, even during the Great Depression. Yet despite California's standing as one of the most prosperous regions of the wealthiest nation on earth, its Governor seems powerless to stave off disaster.

So-called "direct democracy," through which small interest groups can enact laws by making them the subject of an electoral "proposition" or ballot measure that attracts more than 50 per cent of the vote, has severely limited his ability to manage finances.

Property taxes, the mainstay of any state's income, have been frozen for many homeowners since a proposition was passed in the late 1970s. A separate measure, introduced in the 1980s, means that income taxes cannot be raised without the agreement of two-thirds of the state's lawmakers.

Meanwhile, a raft of other ballot measures control spending, meaning that only 25 per cent of California's spending is considered "discretionary". The rest has been "earmarked" for a particular cause or project.

The result has been political gridlock, with the minority of Republicans at the state assembly in Sacramento able to block tax rises, while the majority of Democrats refuse to countenance any cuts in spending.

Mr Schwarzenegger, who declared a "fiscal emergency" earlier this month, has pledged to hold round-the-clock negotiations to find a deal between Democrats and Republicans in his legislature in time for Christmas.

However, public-sector unions yesterday pledged to block his plan to force state employees to have two extra days off a month, saving $1.5bn a year.