The dynamics of informal responses to covariate shocks

Microeconomic theory suggests differential resilience of formal and informal instruments to natural and man-made shocks. Informal risk instruments effective in managing idiosyncratic risks are predicted to collapse in the wake of covariate shocks. This position leads to two hypotheses: (1) that covariate risks are more virulent, thus less resisted by informal instruments, demanding market or state intervention (which are more resilient) to manage aggregate shocks when they occur; (2) that idiosyncratic shocks are less aggressive than covariate shocks, thus can be reasonably accommodated by informal mechanisms. Using empirical evidence, this paper argues that there is no such clear evidence of the superiority of formal instruments over informal responses to covariate shocks. Rather, improper understanding of the dynamic response of informal instruments to aggregate shocks is a prime motive for its underestimation. The paper concludes with suggestions on pertinent research issues that could better capture and explain the role of informal structures in managing shocks.