SACRAMENTO — A slowing economy — led by the weak housing market — has opened up a potential $10 billion state budget shortfall over the next two years, just 20 months after Gov. Arnold Schwarzenegger was plotting how to spend an unanticipated multi-billion windfall in tax revenues.

The state Legislative Analyst's Office report Wednesday gives yet another indication of how quickly California's fiscal fortunes have turned and how volatile the state's revenue stream can be.

The sharp fiscal crunch puts new pressure on Schwarzenegger and lawmakers to consider sharp spending cuts and possibly tax increases at a time when state leaders are in the midst of tackling one big-ticket reform measure — universal health care — and about to begin work next year on another, potentially more expensive, overhaul of public education.

Just three months ago, the Legislature passed what was

believed to be a balanced budget for 2007-08 that had a $4 billion reserve. Now, the state is likely to face a $2 billion shortfall in the current fiscal year — a swing of $6 billion — and another $8 billion gap next year.

The problems are driven by a combination of declining revenues caused primarily by the weak housing market; a growth in spending for pay raises; a $500 million pension lawsuit; and $174 million to fight the Southern California wildfires.

Hill said the state has already used up all its quickest fixes to deal with budget shortfalls because of long-term deficits that have lingered since the dot-com collapse earlier in the decade. Future budget-balancing measures, she predicted, will be more and more painful.

"The key thing to remember is all the easy solutions are gone," Hill said. "To get revenue and spending lines into balance will require some really tough choices."

Schwarzenegger has already reportedly instructed state agencies to prepare cutting up to 10 percent in next year's budget. Schwarzenegger has consistently opposed new taxes since he was elected, and Finance Department spokesman H.D. Palmer said the administration's focus now is on looking at ways to cut spending, rather than raise taxes.

"Knowing the challenges that we face, throughout the fall, my administration has been examining a variety of options to close next year's budget gap," Schwarzenegger said in a written statement released Wednesday.

"I have not made any final decisions yet, but it's clear that the decisions that will be involved will be tough. I have a constitutional requirement to submit a balanced budget to the Legislature in January and I will fulfill that responsibility."

The report landed on the same day that Schwarzenegger's predecessor, Gray Davis — recalled by voters amid his own budget crisis — happened to be speaking in Sacramento. When asked for a solution to California's chronic economic fluctuations, Davis reached for a page straight out of a conservative playbook: a constitutional amendment to cap spending.

"The only way to avoid this roller coaster ride is to have a constitutional amendment in place that requires that you put aside three to four percent of the budget and only draw down on that when the economy is weakening," said Davis, addressing the Sacramento Press Club.

"I hope that as a bi-product of dealing with this budget challenge that the governor and the Legislature deal with this larger question of putting a spending limit before the voters so we'll have some stability."

Davis said the key is convincing interest groups — including education, which has a guaranteed funding formula approved by voters — that no one is insulated from the ups and downs of the economy.

"It's not realistic for groups to say we have our money locked in no matter what happens," said Davis, now an attorney for a Los Angeles law firm, Loeb & Loeb. "It's important for people to accept that reality."

Davis said he takes no pleasure in watching the state head toward a fiscal morass under the man who ousted him in the 2003 recall — and after overseeing one of the worst budget crises in California history. Schwarzenegger inherited a deficit of $16.5 billion.

"Life is like a relay race," he said. "When you have a baton you run as hard as you can and hope the next guy doesn't run in a different direction. I'm glad the governor has not run in a different direction."

The governor's office said it could not comment on Davis' suggestion without knowing more details, but the governor pushed for a different balanced-budget initiative in 2005 that was rejected by voters.

Conservatives lauded Davis for embracing what has been their siren call.

"In concept, we applaud the suggestion that we've been pushing for 30 years," said Jon Coupal, president of the Howard Jarvis Taxpayer Association. "When you have someone like Gray Davis, who was burned by overspending, say this, it's like a reformed alcoholic. This church is big enough for all sinners."

Schwarzenegger must submit his proposed budget in January, and Assembly Speaker Fabian Nunez, D-Los Angeles, wasted no time Wednesday insisting that the Legislature will not accept a budget balanced on the backs of the poor.