(FORTUNE Magazine) – There is no more interesting tale of power--how to get it, how to leverage it, how to wield it--than the one unfolding now in Sacramento. Here, a deeply bronzed, well-chiseled creature of Hollywood stalks the shabby halls and threadbare offices of the state capitol building, striking fear into the hearts of career politicians, wreaking havoc among entrenched bureaucrats, trying to break the gridlock that brought California to the brink of bankruptcy. Call it Terminator 4, with Arnold Schwarzenegger starring in the greatest role of his life.

Who would have thought it last October, when the California recall election was fodder for political cartoonists and late-night comics--and the action hero was part of the punch line?

Within days of his Nov. 17 swearing in, the new governor had readied a credible economic recovery plan. Within months he'd crisscrossed the state, cajoling skeptical Californians to support two critical referendums: one allowing him to do a $15 billion bond deal to refinance some of the state's debt and another requiring a balanced budget. Then he did something that shocked even his most cynical Democratic rivals: Through a combination of optimism, charm, and sheer willpower, the new Republican governor muscled through the legislature a bill to overhaul the state's skyrocketing workers' comp costs. The program had been broken for years, despite various ineffectual attempts to fix it--and had come to symbolize the impotency of state government. But Arnold, as Californians call him, pushed through the reform legislation as if he were, well, the Terminator.

Indeed, in the first months of his administration, the governor has proved a far better politician than most everybody had thought. "I don't think anybody was prepared for the extraordinary skill with which he's conducted the job," says Kevin Starr, a history professor at the University of Southern California who recently retired as state historian. "If he's a rookie, he's rookie of the year. He's more successful right now than Reagan was at this stage."

Now, though, he is locked in a monumental test of wills--with career California Democrats, right-wing Republicans, and special interests. They have unraveled his $103 billion budget plan and wrecked his campaign promise to meet a June 30 deadline for passing a new budget. They have also shattered his hopes of a quick, heroic turnaround of California's fortunes. The battle is taking every ounce of Schwarzenegger's focus and testing his eternal optimism and good nature. Lately, as his frustration has grown, he has begun to sound less like the charming Kindergarten Cop and more like the bully Terminator, stirring up a hornets' nest, for instance, by calling his opponents "girlie men" at a recent rally. California is holding its breath.

It won't be the last time either. By the time you read this, California will probably have a budget, but there's no telling how Schwarzenegger will come out. In fact, his political career may be a lot like his movies with lots of wreckage and smoke and moments of suspense while the crowd waits to see: Will he really be back? That's because his style of political power is one we haven't seen in a while: the power of the persona. It has little to do with the backroom arm-twisting and wheeling-dealing--and everything to do with charisma, personal magnetism, and the ability through gesture and example to get people to follow. This power relies on high approval ratings. It practically requires the courage to take big risks. It's unclear whether, in Schwarzenegger's case, it's sustainable, given his lack of political experience, his colorful past, and his occasional propensity for outrageous comments. But he's already made some impressive converts. "He's landed on Normandy Beach. He hasn't marched through France yet," says his friend and advisor Warren Buffett, referring to Schwarzenegger's efforts to turn the state around. "But the result will be the same--victory."

If you want a case study in the accumulation of power, you won't find one more striking than that of Arnold Alois (his middle name means "famous in battle") Schwarzenegger. He is a man of tremendous ambition and astonishing will, motivated early on by a harsh, claustrophobic childhood in tiny Thal, Austria, and by dreams of grandeur that would be labeled delusional--except that he achieved them. As a youngster, he writes in his autobiography, he was "impressed by stories of greatness and power." His idol, though, was a bodybuilder named Reg Park, whose pictures he pasted on every wall of his bedroom. He decided early on that "the bigger you are and the more impressive you look physically, the more people listen and the better you can sell yourself or anything else."

His life has been variations on, and refinements of, that theme. Today, approaching his 57th birthday, he sits back during a break in the endless rounds of budget meetings in the "deal" tent he has set up in the courtyard outside his office to avoid California no-smoking laws. Puffing a cigar, he considers the subject of power. "I really don't like the word 'power,' because sometimes it has the wrong connotation," he says. "Power is basically influence. That's the way I see it. It's being able to have the influence to make changes to improve things."

Power, Schwarzenegger muses, requires a clear vision. "I know it from my bodybuilding--that I can see my goals very clearly." Beyond that, it takes passion. It takes the confidence to ignore critics and naysayers. It takes the ability to command lots of attention--and then to use that attention to persuade people to adopt your position. Now his heroes are people like Mikhail Gorbachev: "Can you imagine someone who has come from within the system, he was communized from A to Z, worked his way up to become president of one of the powerful nations in the world and then to say, 'We have the wrong system'?" Arnold dwells on that for a second. "Incredible," he says.

It is one thing to see this guy on the screen; it is another entirely to see him in person. He is larger than life. He is funny and smart, with a voracious curiosity about everything from human physiology to macroeconomics. He is disarmingly honest and sometimes outrageous. He couldn't care less about being PC. ("I love smart women," he told me at one point. "I have no patience for bimbos.") He is his own personal brand of moderate Republican--fiscally conservative, socially liberal, defiantly independent, and unabashedly pro-business.

Indeed, his moderate views make the conservative national Republican Party extremely nervous. He's hardly aligned with the politics of President Bush, but his charisma and popularity make him a force to be reckoned with nonetheless. Example: When party operatives appeared to be dithering over whether to give Schwarzenegger a speaking role at the upcoming Republican convention, the governor simply went public and told the New York Times, "If they're smart, they'll have me obviously in prime time." Two days later, he was invited to speak--during prime time. That's power.

Schwarzenegger has a fantastic sense of theater that he has deployed time and again to accrue fame and influence--which he then used to catapult himself forward, building not just celebrity but a brand. He has always been an interesting combination of naughty and nice, and when he steps over the line, it's never quite clear whether it's a gaffe or a ploy. He blows people away with his kindness, gladly helping others at the local gym in Sacramento where he works out, but he is also steel-willed and sometimes combative. Incidents from his past have caused him problems since he entered the political fray. He describes himself as the sum of his own movie roles. "I have two personalities," he says. "One is the really kind, childlike, funny, silly one," like Twins and Kindergarten Cop. "But I am also the anything-that-is-in-front-of-me-will-be-eliminated type of a character."

It's almost as if he's trying to recast the definition of "leader": larger than life, less than perfect. He is the antithesis of powerbrokers like L.B.J. He abhors special interests and has given back six-figure checks that came with strings attached. Last spring, in front of a roomful of Wall Street executives, Buffett compared the new governor to F.D.R. Roosevelt had a long cigarette holder; Schwarzenegger has his cigar. Roosevelt was a master of carefully choreographed PR who could electrify a crowd; so can Arnold. F.D.R. had a trademark smile that he used to convey unwavering confidence and move public opinion to his side. And like Schwarzenegger, F.D.R. had an iron will, born of past pain.

Schwarzenegger was shaped by his Eastern European roots, his scrappy self-determination, and his irrepressible optimism. Although he adores many things Austrian, he has a love-hate relationship with his native land. The discipline he got growing up "would now be called child abuse," he explains in an interview at his home. "My hair was pulled. I was hit with belts. So was the kid next door, and so was the kid next door. It was just the way it was. Many of the children I've seen were broken by their parents, which was the German-Austrian mentality. Break the will. They didn't want to create an individual.... It was all about conforming. I was one who did not conform and whose will could not be broken. Therefore I became a rebel. Every time I got hit, and every time someone said, 'You can't do this,' I said, 'This is not going to be for much longer, because I'm going to move out of here. I want to be rich. I want to be somebody.' " Then, with a twinkle in his eye, he adds, "Of course, I had no plan how."

But he had a picture in his mind of Reg Park, and despite his parents' objections, he pursued bodybuilding with a vengeance. At one time Schwarzenegger's biceps were the size of cantaloupes, and he could bench-press 520 pounds. His goal was to become Mr. Universe, which he did by age 19. Over the next eight years, he won 13 more championships. In 1970, he beat Reg Park for the Mr. Universe title.

He made it to America by age 21, and within two years he had his first starring role. He has since made 33 more movies and now ranks among Hollywood's top earners--pulling down a staggering $30 million for playing Terminator 3 last year.

Buffett believes that Schwarzenegger's ability to virtually will himself into stardom stems directly from bodybuilding. "Have you ever lifted weights?" Buffett asks. "When he talks about that last rep, you know, when you've curled however many pounds 16 times and your body's screaming at you--he did that. He always visualized success.... That really is the kind of thinking that gets things done. If you think you're going to succeed, you will."

As it turns out, Buffett and Schwarzenegger had something in common. As a kid, Buffett was so taken with weightlifting that he twice hitchhiked from his home in Washington, D.C., to the York Barbell company in York, Pa., to hang out with, as he puts it, "the gods of weightlifting" and their legendary coach, "Uncle Bob" Hoffman. "I didn't do that last rep, though," laughs Buffett. "I had to find other ways to impress the girls."

Schwarzenegger took the same approach with Hollywood that he'd taken with bodybuilding: Nothing was going to stop him from being successful. "One of the great differences about him was that he had a professional business attitude about being a star," says Ivan Reitman, who produced and directed him in Twins and Kindergarten Cop. Schwarzenegger says he was always thinking, "How can I convince the world ... to get out of their home and go watch me?" He was a tireless promoter of everything he was involved in--his movies, his books, his volunteer projects. He did a 30-city book tour for his Encyclopedia of Modern Bodybuilding, visited 64 countries to promote the Special Olympics, met every governor in the country as chairman of the first President Bush's Commission on Physical Fitness. Along the way he collected a surprising assortment of friends and advisors--not only Buffett but celebrities, politicians, economists like Milton Friedman, and statesmen like former Israeli Prime Minister Benjamin Netanyahu. And, of course, as he promoted his ventures, he promoted himself--and accumulated the power of celebrity.

He learned to turn a deaf ear on doubters. "Other people would say, 'This can never happen. There's the talent problem. There's the language problem. The name itself--Schwarzenegger--no one can pronounce it,' " he recalls. "Those were their obstacles, not mine." If his name was difficult to pronounce, he told himself, then it would be unforgettable.

The Terminator, which came out in 1984, gave him the first of his memorable lines--"I'll be back." Twenty years later that line still has such currency that Martha Stewart used it after her sentencing--and he uses it to this day to rally his supporters. The lines themselves have become a source of power. "To say to your enemies, 'I'll be back.' And then suddenly you are back. And you get your way. That is everyone's dream," he says.

Over time it would all add up to this: a consistent ranking in the top 3% of movie stars and personalities for fame and appeal, plus a name worth "millions of dollars," according to lawsuits his lawyers have filed to protect his market value. In other words, a perfect platform for politics.

His politics, naturally, would be a synthesis of ambition, optimism, and free-market evangelism--tempered by a marriage that made him a part of the Kennedy family. Upon his arrival in America in 1968, he heard Richard Nixon campaigning for free enterprise, "getting government off our back," strengthening the military--all of which made sense to a kid from Austria, with its strong socialist party, next door to the dangerous Soviet bloc. Schwarzenegger became a Republican because Nixon was one.

Then, in 1986, he married Maria Shriver, daughter of J.F.K.'s sister Eunice and Sargent Shriver. "We talked up a storm when I mentioned Nixon in that house," he laughs. The Shrivers didn't totally turn him around on Nixon. "It was very clear there were certain flaws that he had, but ... there was also an unbelievable strength," says Schwarzenegger. But the Kennedys embraced him and bombarded him, surrounding him with political conversation, making him an advocate for, and true believer in, the potential of the disabled. Eunice Shriver, he says, is constantly sending him books about inspirational leaders, with sticky notes on the pages she wants him to read. He believes it was she who helped persuade a reticent Maria to let him pursue the governorship.

When he began to seriously contemplate the notion last summer, as the recall election of the unpopular Democratic governor Gray Davis went from being an idea to a reality, he had no shortage of friends, movie stars, economists, and government leaders with whom to consult. He knew California was in dire straits, but he wanted to satisfy himself that it was fixable. During the tech boom, revenue had soared and expenditures had swelled. But once the bubble burst, revenue plummeted. In 2001 and 2002 income tax receipts alone fell by 27%, yet state spending remained at boom-year levels. By the end of 2003 the state would be $22 billion in debt and have a projected budget deficit of $15 billion, with $14 billion in short-term borrowing coming due the following June.

His friends and advisors assured him that the state could be turned around--and they all had ideas on how he should do it. Milton Friedman told him that he needed to pay down the debt, stimulate the economy, lay off the taxes, unshackle business. Buffett told him that California was like a 500-horsepower engine running at 50. It needed a leader to refinance its debt, break the logjam, and most of all, restore confidence. Even Netanyahu had some advice: Make business strong and put government on a diet. These suggestions jibed precisely with Schwarzenegger's lifelong leanings.

On an airplane last summer, flying around the world to promote Terminator 3, his vision of what he could do for California came into sharp relief. The new governor, with a mandate from the people, would bring Democrats and Republicans together to save the state from bankruptcy. They would pass a balanced budget and do it by the statutory deadline--the first time since 2000. Then, with a turnaround underway, he would turn his attention to what really mattered: moving California into a glorious future. He would reinvigorate the business community, rebrand and repackage the state, and then travel the world to say, "We're back. We're open for business." Business would embrace California. The rising tide would lift all boats.

That scenario would become the basis of his quickly thrown-together campaign. And while the East Coast political elites couldn't begin to get it, Californians ate it up. They were searching for someone who could lead them out of the mess they were in. And besides, this was hardly the first time a movie star had made a successful foray into California politics. What's more, some of the state's most successful governors, including Earl Warren and Pat Brown, had pragmatically blended liberal and conservative views to govern from the center--just as Schwarzenegger hoped to do.

His action-figure image did more than give him instant name recognition. The violent roles, the smoky cigars, the faux tan, the past naughtiness just didn't seem to cause the normal objections--voters didn't really expect a character like Arnold to be, well, normal. When his past indiscretions became campaign fodder, Californians gave him the benefit of the doubt. They were even willing to dismiss last-minute allegations that he'd groped and humiliated women in the past.

"I knew some of the charges were untrue, because that's not my style," he said, recapping his explanation during one of our interviews. "To lift someone's shirt up and to expose her, I mean, never in my life would I do that, because that's not cool. It's not me. To hug a girl, to kiss a girl, to pat someone on the butt--I could have done that. Maria has always said this behavior will get you into trouble. I make mistakes. I made those mistakes, and I regret it," he says. After taking office he, along with his staff, took a seminar on diversity training and sexual-harassment prevention. "To me, what was acceptable then is not acceptable now. I have changed," he insists. He won the election--against a gaggle of other candidates also running to replace Davis--with 48.6% of the vote.

Schwarzenegger installed a gold plate engraved with his name above the solid oak doors of the governor's office so that the tourists and school groups who often gathered in hopes of catching a glimpse of him would have something to take a picture of. He ordered up his now-famous khaki canvas tent outside his office. Though it's initial purpose was to sidestep California's no-smoking laws, it quickly became more than that: It became a symbol of power and a neutral ground for dealmaking.

From the start Schwarzenegger held out the olive branch, breaching the line of demarcation that had separated the governor's first-floor offices from those of the legislators. He actually walked down the hall, around the corner, and rode the elevators upstairs to meet with legislators in their offices; his chief of staff Pat Clarey can't remember that happening in the past four administrations. He also invited all 120 legislators, several at a time, to his tent to get to know them.

Eventually his biggest rival, John Burton, Democratic president pro tem of the California senate, who boycotted Schwarzenegger's inauguration and barely shook his hand at their first meeting, began to thaw. The governor wooed him with public praise, visits from Maria and Eunice (Burton had campaigned for Sarge way back when), and a box of See's candy signed by Buffett. Burton, a cantankerous 74-year-old who was first elected to the state assembly in 1964, concluded that maybe Schwarzenegger wasn't so bad after all. He began to drop in frequently at the governor's office to negotiate, speak some German (he was stationed in Austria while in the Army), and sometimes just "talk about nothing."

Schwarzenegger was making it look almost too easy. As soon as he was elected, he repealed the car-tax increase, which Californians hated but which would have raised an additional $4 billion in revenue. He persuaded a stubborn electorate to pass propositions 57 and 58 in March. Those were the referendums that made the $15 billion bond offering possible and required a balance budget. Though only 30% of the electorate favored the propositions in February, they passed by a wide margin just a month later. Then, with advisors George Schultz and Warren Buffett by his side, he sold the bond deal to Wall Street.

In April he convinced the legislature to pass a bill to overhaul workers' compensation, reducing a major business cost. That victory, in particular, shocked senator Burton. "I would have bet a million dollars he never would have got the workers' comp deal," he says. Schwarzenegger, he adds, "starts out at one place, and we start out at another place, and he just keeps driving until we get a deal." By May, Schwarzenegger's approval rating had risen to 65%, the economy was picking up, and the ratings agencies were upgrading the debt, reflecting (according to Moody's) steady job growth and an improved budgetary outlook.

Schwarzenegger dove into his first budget season with his usual optimism, convinced that he'd make his June 30 deadline. He negotiated budget cuts directly with the state universities, and the prison guards' and teachers' unions. Though he still lived in Los Angeles, he spent weeks at a time in the Sacramento Hyatt, working late into the evening and even skipping the gym. Then he made a mistake. A deal he'd made to protect local governments from having their treasuries raided by the state began to unravel because, it appears, he'd made conflicting promises to both sides. Instead of racing to finish the budget negotiations, the legislature left for the July 4 weekend--and everything began to unravel.

EARLY ON SUNDAY, JULY 4--FOUR DAYS AFTER HIS BUDGET deadline had passed--Schwarzenegger stepped into his driveway, looking a lot like Terminator. He was wearing a black leather jacket, boots with silver chains, black helmet, and goggles. The saddlebags on his Harley motorcycle were studded with silver. It was his first day home in two weeks, and he was going to meet up with "some of the guys" for breakfast.

He gunned his Harley and headed west to the Pacific Coast Highway, nodding at some of the passersby who shouted at him along the way--and causing fits for the California Highway Patrol following along behind. This ride, past Topanga Canyon and into the hills, is one he's been taking for 20 years. And "the guys" who joined up at various points along the route were a strange breakfast club--movie stars, bodybuilders, Hollywood directors, business partners. Often they number more than a dozen; on this day, though, there were just four, among them comedian Tom Arnold, who co-starred with Schwarzenegger in True Lies and is currently one of the hosts of The Best Damn Sports Show Period.

They all pulled up outside the Rock Store, a biker hangout in Malibu Canyon, and Schwarzenegger parked his alter ego outside with his bike. Inside, it quickly became clear how obsessed the governor had become with the budget impasse. No, he said to an incredulous Arnold, he had no idea that the Lakers might lose Shaq. "Hello? Basketball?" said Arnold. His attention had been elsewhere. Over oatmeal, he explained that he had hoped to make an appearance in Times Square in New York, to tell the East Coast that California was back--but he obviously couldn't do that until he had a budget he could sign. "I tell them [the legislators], 'Don't get stuck on the Mickey Mouse things,' " he said. By which he meant: Don't get hung up on the minutiae of one fiscal year's budget when the real business--the business of getting California growing again--still lay ahead of them.

Later, back at his home in Brentwood, he spelled it out clearly: "The legislators can play the important characters in this play. I want to declare victory together. That is my ultimate goal," he said. Then his tone turned steely: "But there is no one, and when I say no one, I mean no one, who will back me off my vision. I will go over burning coals for that."

Over the ensuing weeks, as contentious negotiations continued--and deals already struck sprung new leaks--Schwarzenegger started spending less time in smoky meetings at Sacramento and more on the road--shaking hands and firing up crowds in Cheesecake Factories and pizza joints and shopping malls from Stockton to San Diego. He was using power the only way he knew how--persuading voters to rally around his position. One day not long ago, for instance, in a mall in Chico, he was surrounded by a cheering crowd as he moved gracefully to the stage. "I'm asking you a simple question," he boomed. "Shouldn't the government terminate reckless spending?" The crowd roared. "To the special favors and to overspending and to higher taxes, I say, 'Hasta la vista, baby.' " The crowd went even wilder. "I need your help once again," he said. "Send the message to Sacramento that the time is now for the budget.... Call every day, send e-mails, write letters to the legislators.... I will continue being the people's governor. I will continue serving all of you. And I promise you right now, I'll be back."

As he's repeated the performance again and again in recent weeks, he's sounded increasingly combative. At one point he called his legislative opponents "girlie men," implying that they were wimps for not stepping up to his budget. Lately he's been threatening to campaign to unseat those legislators who don't fall in line--which, of course, has infuriated California Democrats, who point out, correctly, that they will continue to control the California legislature for the foreseeable future, no matter what the governor says or does. Burton, for one, stopped fraternizing with Schwarzenegger. Democrat Fabian Nunez, the speaker of the assembly, and an outspoken opponent of Schwarzenegger, says: "The governor has to define who he is. Is he the diplomat? Or is he the rambunctious politician who is going to pick a fight and bully around Democratic legislators?"

Schwarzenegger's decision to go public on the budget fight, instead of wrangling behind the scenes, has also drawn a torrent of criticism from the California papers, and cost the governor some of his precious popularity--though his approval rating is still a healthy 57%, according to a recent poll. But not everybody thinks it's a mistake. "Al Capone said, 'You can get more with a smile and a gun than you can get with a smile alone,' " says Warren Buffett.

In fact, it's hard to imagine Schwarzenegger reacting any other way. Getting in front of crowds, sounding his themes, shaking hands, generating enthusiasm, even striking out at opponents--that's the essence of who he is as a politician. It energizes him--and it's what makes him effective. It's the source of his power, something he understands all too well, even if his critics don't.

Sooner or later, of course--and probably sooner--California will have a new budget, and no matter what's in it, Schwarzenegger will declare victory. He can picture it all: He'll go to New York and proclaim that California is back. The business community will get jazzed again about California, and the state will start to grow its way out of its economic problems. New jobs will be created. Legislators will come by his tent again to share a smoke and bask in his charm.

After all, when you've spent your life visualizing success, you're not going to stop just because you're now the governor.