Informality and the Labor Market Effects of Financial Crises

We provide evidence, based on a large sample of countries, on the effects of financial crises on key labor market indicators, including official and unofficial employment, unemployment and the participation rate. Crises are followed by a drop in the official market participation rate and by an increase in informal employment. These responses are strongly persistent. Empirical results are then interpreted with a DSGE model which accounts for informality and for financial and labor market frictions. In this framework the informal sector acts as a buffer which absorbs workers in bad times and vice versa. Our simulations suggest the informal sector also is a crisis amplifier for the official economy. In fact, the larger the pre-crisis informal sector, the stronger the labor reallocation, i.e. the fall in the participation rate, necessary to equilibrate the labor market.