I have been asked to explain on how government defaults take place.
Government defaults are very unpredictable events, and so they are hard for economics to predict or model.
I think only history can be a very rough guide: Defaults that work go something like this (based on 1932 Greece or 1931 UK). I define a good default one that lead to recovery of GDP within 18 months.
a) You stop paying international creditors (so the 1.3 bn in june becomes less threatening). You put capital controls and close borders for 2 days. You convert all deposits to new currency and notes and coins in banks (do not even need to print currency - you an stamp all euros).
b) The hard part: You need to Balance your current account (imports/ exports) and your government account (the hardest as deficit will be 0 - but you have no interest payments). Both of these will be a rude shock to GDP, much harder and ruder than any bailout/austerity package. But some argue it is a one shot game, rather than a prolonged period of austerity.
However it is interesting to note that all Eurozone countries eliminated a large part of their currency reserves when joining the Euro (they became Euros). Thus you would need to start from the beggining, maybe keeping a current account surplus.
c) A mixture of inflation and growth will ensure - the key is you do not know how much of each before the default!
Inflation will arise: I do think inflation will be bad, and you will have fuel shortage as well. After some time J curve effect will make your exports very competitive. However it is important to remember that inflation transfers income from to those who own supermarkets to those who shop there. All the big Greek families with famous names became super rich when the exit from the gold standard took place. It is also true that inflation destroys the middle class. In that case savings will be hurt, perhaps far more than the 6.75% that were now subjected by the memorandum. Some argue however, than you can stop this cycle of inflation by correctly issuing your currency - ending fiat currency and only backing it on assets.
d) The new currency needs to be backed on something: I would back it on the assets of the troubled banks and not have fiat circulation i.e. all circulation of pounds will equal the assets of the banks and the government. If you did that today those assets should be more than Euros in circulation. This should not reduce the money supply. If this process is done correctly (see UK in 1931) you might stabilize and your new currency will trade to around 30% below euro.
Even so that does mean 30% increase in fuel prices however, making all domestic production more expensive. Thus the export increase effect perhaps muted. I disagree with the analysis that a country like Cyprus does not seek to gain with a devaluation: although the effect could be negative or positive, it is clear that at least three sectors will become competitive:
1) the tourism sector will be very competitive to tourists holding Euros
2) The universities / education sector will offer a 40% cheaper tuition/accommodation costs than UK
3) the existing business services will be able to take on back office outsourcing work from their UK and European organizations, as the cost of a chartered accountant will be much lower.
This default is not a panacea. It is harsh and wrong decisions can make it much more painful.
The first is that there are Common problems/mistakes on defaults:
1) Governments wait too long to leave to default. It becomes obvious to all and subject to speculation and hoarding of currency. Leaving sooner is better. This is something that politicians seem to resist. The UK only left the gold standard quickly when the central governor had a nervous breakdown, creating a lack of communication. In short government never leave a currency union (or other for of currency link) early enough
2) Governments usually print money rather than balance the books. Austerity before hand makes governments not balance their books, with large problems of inflation arising. This is because common sense macroeconomic stability is not followed after a default as people want a break from austerity
3) Litigation can stop a re-entry into the markets. As Argentina has discovered a default without the agreement of all creditors can stop your economy coming back in the international arena. This is the case in Cyprus which has British law bonds, although experts thing that this just makes renegotiation of bond difficult but not impossible
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