Job Market Paper

Insurance Networks and Endogenous Poverty Traps

Abstract

Poor households often do not undertake profitable investments. This is so even when their informal risk sharing networks have the resources to allow one of their members to make such investments. This paper provides a novel explanation for this puzzle: informal risk sharing can crowd out investment. I extend the canonical model of limited commitment in risk sharing networks to allow for lumpy investment. The key insight is that the cost of losing insurance is lower for a household that has invested, since it has an additional stream of income, limiting its ability to credibly promise future transfers, so network partners demand transfers today and investment does not take place. The model generates two key predictions: there exists a non-linear relationship between total income and investment at the network level – namely there is a network level poverty trap – and there is an inverse U-shaped relationship between network income inequality and investment. I test these predictions using a randomised control trial in Bangladesh, that provided capital transfers to the poorest households. The data covers 27,000 households from 1400 villages, and contains information on risk sharing networks, income and investment. I exploit variation in the number of program recipients in a network to identify the threshold level of capital provision needed for the program to move the network out of a poverty trap and generate further investment. I also verify additional predictions of the model and rule out alternative explanations. My results highlight how capital transfer programs can be made more cost-effective by targeting communities at the threshold of the aggregate poverty trap.