The Sacramento Bee today reports – here – that Gov. Arnold Schwarzenegger is preparing mid-year budget cuts that respond to the gaping hole in the state budget. Without revenue increases, that could mean at much as $40 billion in spending reductions over a period of 18 months. (The 18-month deficit has been variously estimated at $40 billion to $42 billion.)

Think pain all around. The deficit exceeds the amount the state spends each year on k-12 education, which just happens to be the largest single budget category. This year, the budget calls for total general fund spending of $103 billion.

Presumably, the governor’s new spending cuts would be rolled out with the 2009-2010 budget proposal due next week.

At the end of last week, legislative Democrats said they were “very close” to the kind of budget deal I described in a previous post. Click here.

But, as the days drag on, there are no new signs of progress. While on vacation, Schwarzenegger and Democratic leaders are said to be talking by phone.

If they reach an agreement, no one can say whether the deal would achieve its objective – which is to reduce the state’s 18-month budget deficit by $18 billion through a combination of spending cuts and new revenues.

Legislative Republicans and anti-tax groups will file lawsuits, claiming that the deal is illegal. State law requires two-thirds majorities in each house to approve a new budget, but Democrats – applying an untested legal theory – claim a simple majority will suffice because the proposal is “revenue neutral.”

Will lenders accept promises that assume this new arrangement is legal? Will a judge dare toss out a deal that spares California from bankruptcy? Stay tuned.