Jim Christie

California Governor Arnold Schwarzenegger and lawmakers failed on Wednesday night to agree to balance the state's budget by closing a $26.3 billion deficit, but officials said talks would continue.

The budget talks, which have lasted weeks, have stalled over a part of the governor's plan to suspend a law on school funding, Karen Bass, the speaker of the state assembly, and California Senate President Darrell Steinberg told reporters.

The legislature's two top Democrats said budget talks would resume on Thursday.

Schwarzenegger, a Republican, had said earlier on Wednesday he was hopeful a deal to resolve the lengthy budget crisis was near and might be reached by the end of the day.

There's no nastiness in the discussions, no blowups, he said at a press conference. There's none of that, so I think we have a good shot of getting the budget done today.

The state government began its fiscal year on July 1 facing a historic budget gap and a severe cash crisis.

California, which would be the world's eighth largest economy if it were an independent nation, has issued IOUs to vendors as well as taxpayers owed refunds to save cash for servicing of state bonds and other priorities payments.

Among sticking points in negotiations are Schwarzenegger's demands for a budget deal including changes to rules he says will prevent fraud in welfare programs.

He has also proposed paring education spending by suspending a voter-approved measure that locks in funding levels for public schools. Democrats oppose both ideas and are especially concerned about education spending cuts.

The size of a budget reserve also is being discussed. A cash cushion may help the state sell short-term debt after a budget agreement is reached. It's all about being able to go out to the market after this is done, Steinberg said.

State Senate Republican Leader Dennis Hollingsworth said the state could use a reserve of up to $2 billion.

California's IOU effort is also intended to calm Wall Street. Credit rating agencies have grown increasingly anxious about sagging state revenues propelled by the recession and double-digit unemployment.

Moody's Investors Service on Tuesday cut its rating on about $72 billion of the state's general obligation debt by two notches to Baa1, or three notches above speculative junk status. Moody's said there may be further downgrades because the risk to priority payments -- and eventually debt servicing payments to bondholders -- is rising without a budget deal.

On July 6, Fitch Ratings cut its credit rating on California to BBB, just two notches above junk level.

Democrats have conceded there will be no tax increases in a budget deal as Schwarzenegger and anti-tax Republicans in the legislature's minority have demanded and have accepted dramatic spending cuts to fill the state budget gap. We have made very, very deep cuts, Bass said.

California