The ongoing epic of the eurozone crisis is by no means over.

Greece will probably selectively default next month (or thereabouts), and then have a pause before properly defaulting (with a debt haircut) at some later date. There are still many other options for crises out there, and politicians will no doubt have many opportunities to create even more.

The central problem in Europe is, as I’ve noted before, that in the long term the euro does not work. The euro has never worked. Economists spent all of the 1990s saying “the euro will not work”. Economists were ignored. Bad things happen when economists are ignored. However, the failure of the euro to work as currently structured is compounding the near term problems that we face by leading to more and more political tension.

To hear the Germans tell it, the solution to the euro crisis lies in the hands of the discipline.

The Teutonic rallying cry of “we must have discipline” echoes around the council chambers of Europe. If only the periphery would knuckle down, raise productivity and lower wages, all would be well. This is exactly what Germany did during the first ten years of the euro’s existence. Germany entered the euro as a very uncompetitive economy. A decade of denial and self restraint later, and Germany was once more restored to the very epitome of competitiveness.

From the Greek point of view, the solution to the euro crisis lies in the hands of Germany.

Greece, as one of the poorest euro area economies, clearly can not manage this process on its own. Greece needs help – Greece is, in fact, entitled to help – from the rest of the euro area. This is, of course, perfectly true. In any functioning monetary union (the US, the UK, the old Italian monetary union pre-1999) the idea is that a fiscal union exists along side the monetary union. If monetary policy is inappropriate for one part of the union, then fiscal transfers will (preferably automatically) compensate the weaker part of the union at the expense of the stronger. It is how monetary unions work.

This then is the tension in the euro area at the moment. To make a dysfunctional monetary union functional, the participants need to exercise labour flexibility and pay restraint, but also to allow the transfers that a fiscal union entails. This was how the US monetary union was pulled out of the abyss of its fragmentation in 1932. It is how the euro can be ultimately salvaged today. But both sides need to see and accept the others point of view.

Greece and Germany are both right. The sooner they both realise that, the better.

Paul Donovan is global economist at UBS, and is guest-editing for FT Alphaville on Tuesday.

This entry was posted by Paul Donovan on Tuesday, July 26th, 2011 at 10:20 and is filed under Capital markets. Tagged with eurozone, germany, Greece. Edit this entry.