Informality and the labor market effects of financial crises

•We estimate the labor market response to financial crises in a large sample of countries.•Financial crises are followed by a drop in participation rate by an increase in unemployment and in informal employment.•We build a DSGE model which accounts for informality and for financial and labor market frictions.•The informal sector acts as a buffer which absorbs workers in bad times and vice versa.•The informal sector is also a crisis amplifier. The larger it is, the stronger the fall in the participation rate. 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. For a given financial shock, the ensuing contraction in the official economy is deeper and more persistent the larger the initial size of the unofficial sector. This implies that in less developed economies financial crises cause a relatively stronger reallocation of inputs towards less efficient sectors, expose a larger fraction of the population to the adverse effects of informality, cause a sharper deterioration of public finances limiting governments ability to supply public goods and to engage in countercyclical fiscal policies.