Understanding the informal economy: The influence of political ideology during financial crises

Abstract

This study investigates both the short- and long-run impact of different types of financial crises on the size of the informal economy, addressing the gap in the crisis-informality relationship. Using a sample of 320 financial crises in 146 countries over the period 1993–2020, we provide evidence that financial crises lead to a persistent increase in the size of the informal economy, confirming that the hidden economy serves as both a safety net for household income and a crisis amplifier. Rising unemployment and prolonged financial crises, especially debt crises, are mechanisms that explain these results. Left-wing governments’ policies, by promoting labour rights and protections, reduce labour market flexibility and consequently expand the informal economy during financial crises. These findings benefit policymakers by offering new insights into the crisis-informality relationship and the influence of political ideology.