The euro's real problem

While it is now widely understood that Greece's inclusion in the euro currency union was a mistake, there is considerable disagreement over where to go from here.

To answer this question requires an understanding of the primary flaw in the euro system. It is not, as many argue, that the countries on the euro are too diverse economically, and consequently cannot thrive under a common monetary policy. Income per capita in the euro zone is not dramatically more variable than it is among the states in the United States, nor are the economies of the euro countries much more diverse in what they produce than the U.S. states. Yet the United States has thrived under a common currency for over two hundred years.

Thus the problem is not the fundamental diversity of the countries, but the fact that each country is fully in control of its own domestic economic policies while not facing the full consequences of their choices. In the U.S., because the federal government dominates economic policy, states have only a limited scope to mismanage their economies. In addition, state and local policy makers know that their residents can "vote with their feet." While these factors have hardly guaranteed good government in the U.S., as recent experiences in Detroit, Illinois, and California, among others, attest, the scale of these problems is not large enough to inflict damage on the country as a whole, or to entice the national government to come to their rescue.

Pro-Euro protesters hold Greek flags during a rally in front of parliament in Athens, June 30, 2015.
Yannis Behrakis | Reuters
Pro-Euro protesters hold Greek flags during a rally in front of parliament in Athens, June 30, 2015.

In Europe, by contrast, there is no central fiscal authority. Each country makes its own economic policies. Moreover, it is not nearly as easy for labor to flow from one country to another: There are language difficulties, separate social security systems, and numerous regulatory barriers to employment of immigrants. At the same time, the fragility of the union is such that countries in the euro union may reasonably expect to be bailed out of any major difficulties. While countries on the euro agreed to rules constraining their fiscal policies (limits on deficits, for example), there were no enforcement mechanisms, so not surprisingly within a few years the rules were widely flouted, and nowhere more so than in Greece.

In essence, the euro countries were like teenagers given credit cards and told by their parents (Germany and the European Central Bank) to behave themselves. Some did, but the Greek government threw a big party and left the rest of the euro countries with the bill. Not only that, it has committed itself to more parties in the future (in the form of pension obligations) while not taking steps to earn enough money to pay for them.

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The parent-teenager analogy only goes so far, however. While Greece, with a population less than Ohio's and GDP less than Connecticut's, is too small to have a major direct impact on the rest of the world, taking away the kid's credit card and throwing him out of the house is not an option the parents seriously want to consider. First, it would still leave them (along with other creditors) holding the bill. Second, it would not solve the Greeks' problems (though it would probably be good for them in the long run): Even relieved of their external debt, they still face huge budget shortfalls and unfunded pension liabilities. Perhaps most important, it would set a dangerous precedent for the other "periphery" countries (Spain, Italy, Portugal) that have flirted with insolvency in recent years. The euro is barely 16 years old, and a "Grexit" would jeopardize the union by giving countries an out if they get into trouble.

At the same time, Germany and the other euro countries must recognize that they will be unable to induce Greece to repay its debts. The ideal solution is thus a compromise in which some debt is forgiven, but only in exchange for major economic reforms, including cuts in pensions, reductions in the massive Greek government budget and civil service, and reforms to a labor market riddled with arcane regulations that inhibit competition and innovation. Of course this general proposition is largely accepted by all parties. The problem has been to negotiate the terms — how much reform, how much forgiveness? Viewed in this light, the recent referendum vote was thus not a rejection of the euro (most Greeks want to remain in the union), but a collective posturing for a better deal. The threats by Greece's creditors can similarly be seen as negotiating stances.

Given how much is at stake for both sides, it is thus not surprising that they have reached a tentative agreement that will allow Greece to remain on the euro. The harsh terms imposed on Greece — no debt is actually forgiven, and Greece will be required to institute reforms, cut pensions, raise sales taxes, and surrender state assets — reflect not just a principled view that Greece must take responsibility for its current predicament, but also the unusual leverage its creditors have because of how costly a departure from the euro would be for Greece. Perhaps most important, the threat of harsh punishments for bad behavior is the only tool remaining to try to keep other peripheral countries from going down the same path as Greece.

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In fact, some of the perceived harshness is only by comparison to an unsustainable status quo ante. The Greek standard of living was built on a lie, and one way or the other was going to decline. Even so, the creditors may have overplayed their hand. There is a sort of Laffer curve for debt repayment: At some point, by demanding more, creditors end up with less. Requiring higher taxes for a country that has trouble collecting on those it already has, and refusing to forgive any of the debt (and thereby acknowledge their own role in abetting Greece's profligacy), may offset the benefits of pro-growth reforms and make it difficult for the Greeks to climb out of the hole. The result could very likely be a repeat crisis in a few years, one that would again require a bailout or exit from the euro, and that could lead some erroneously to conclude that the reforms were counter-productive.

More generally, even if a workable and sustainable agreement is achieved, it will only solve a short-term problem, and not the fundamental contradictions of a currency union with sovereign economic policy-making, no means of enforcing fiscal discipline, and non-integrated labor markets. A failure to address these deeper problems will inevitably lead to recurring crises and ultimately to the demise of the euro.

Commentary by James A. Kahn, former vice president of research at the Federal Reserve Bank of New York. He is now the Henry and Bertha Kressel University Professor of Economics and chair of the Economics Department at Yeshiva University in New York. Follow him on Twitter @jamesakahn.