Town Watch can start a chain rout.thats why.
I usually have normal decent level units in my towns - capable for keeping the order and defending.
Correct.

Since Town Watch aren't effective at defending OR reducing unrest - as bad as Peasants in battle and worse for reducing unrest - how would you go about making them useful?

Since they are described as a "Police" Unit, how about giving them a slight law bonus, like Temples, etc? Raise upkeep slightly to compensate for the bonus and keep Peasants as a viable option?

What would be balanced and make sense?