THE THEORY OF OPTIMISTIC EXPECTATIONS BY L. I. PETRAZHITSKY. 100 YEARS AFTER. Dr. Serhei Lukin. Belarus State Economic University. Minsk. Belarus.

Professor of Saint-Petersburg University L.I. Petrazhitsky was one of the most acknowledged researchers of the stock enterprising in Russia. Unfortunately, his extensive work, published in 1911 still waits to be properly assessed by economists, psychologists and lawyers.

The research of Petrazhitsky is directed against classic liberal paradigm of abstract “homo economicus” behavior, which integral part is rational behavior. «All this work, - points out Petrazhitsky, - serves as an evidence of necessity to put theory and history of economic (and politic) processes on scientifically-psychological ground… instead of using all kinds of psychological fictions and naiveties, like the assumption of total egoism combined with omniscience about present and future, used as a basis for economic laws in modern economic publications». As applied to the stock business, Petrazhitsky puts his theory of optimistic expectations and optimistic increase in opposition to the concept of rational behavior. One of the basic ideas in his argumentation is the statement, that the economical activity of the joint-stock enterprise is not originated from the stockholders. The stockholders are, in the essence, not the entrepreneurs, but the «creditors», whose profit is not of the businessmen’, but of the investors’ nature.

The second assumption, developed in other Petrazhitsky researches, is the psychological law on the possibilities of emotions to control intellectual processes and force them into single direction, force false conceptions, «all the way to illusions and hallucinations» and eliminate contradicting ideas and considerations. «This psychological feature can be seen especially clear and graphic, if the estimated chances can be accessed by mathematically precise calculations, and the results of this calculations shows prevalence of the negative chances, when this negative prevalence can be uniformly applied to every person, taking risks… This psychological feature of the citizens… is a source of sure advantage of the governments, earning money on lotteries». That is, the influence of emotions, namely the optimism, exaggerates the possibility to win, and the rational reasoning on the extremely small chances to win is not taken into consideration.

Supported by these two basic ideas, Petrazhitsky makes following conclusions on the motives of the investor’s behavior. Certain vagueness of the future profit addresses the «lottery» motive of this behavior, leading to optimistic profit expectations, «optimistic increase» (Petrazhitsky’ term) to the future income. The more is the uncertainty in the aims and the results of the joint-stock company, the bigger is the optimistic increase. In normal situation, the optimistic increase enables the joint-stock enterprises to exist, allowing the founders to gather funds to start business activities. In cases of stock boom, the rapid growth of the optimistic increase gives dubious businessmen a chance to acquire substantial resources in short time, without real intention to use them for any activities. We should note, that Petrazhitsky didn’t equate stocks and lottery game, but thought of the optimistic expectations as of important, often determinating psychological factor, influencing the demand and, respectively, the market price of the stocks.

Optimistic increase, according to Petrazhitsky, gives a possibility to gather funds and invest them into business, giving, for example, 5% of the profit, when the public is interested in at least 10% of the profit. The missing 5% is the size of optimistic increase, which is added by the public to the «internal value» of the share. Petrazhitsky sees here a resemblance with a Ricardo rent law, because the rise of the demand in the stocks market creates the conditions to involve less «fruitful enterprises».

The strongest part of the Petrazhitsky research is the analysis of the investors’ psychology in the stocks boom situation. He starts the analysis from distinguishing the uncertainty factor, «factor X», that plays important role in strengthening the «lottery» part of «eventual wins» and, respectively, in the rise of optimistic increase. When establishing of the enterprise, that aims for producing and marketing well known goods, with predictable expenses and market price, the stock exchange fluctuations and rapid growth of stock prices are not to be expected. The «lottery» element will be minimal for such stocks. The influence of the optimistic increase, respectively, will be insignificant too. «On contrary, for the enterprise with «big expectations»… if the features of the new enterprise, it’s technical results, market demand for this results are in general the «X», so the big bonuses as well as big losses can be equally expected… our law because of it’s own nature finds favorable conditions to fully and sharply manifest itself. This deductive conclusion from our theory finds lots of evidence in the history of the stocks market. This history constantly repeats the fact that the disproportionally big… stock price usually seen in different countries… first, in the cases of distanced, abroad enterprises, that are a big Ex for the common people because of the distant location and unexplored status of that lands (John Lo) second, for the enterprises of a new type before they ceased to be «new» (railways, asphalt, credits mobiliers). In its essence, every story of the stock epidemic describes almost exclusively «the life of the enterprises of this kind». We can add to this the example from the modern history, namely stock boom of the middle 1990-ties. Stock business and stock market in Russia in general was big «X» for the potential stockholders. From the theory of the optimistic expectations perspective it’s easy to understand the enthusiasm and optimism, which helped to sell stocks of «МММ», «Hermes», etc. with very little information on the purpose of these companies. By the way, when analyzing the influence of factor «X», Petrazhitsky made a conclusion about stock policies, stating that «…as far as it’s possible to do tuning existing legislation, we shouldn’t allow this X-es to exist in emission prospects etc. if it’s possible to replace them with certain information». In Russian Empire, due to licensing system in stock policies, these X-es were largely reduced. In Russian Federation of the middle 1990-ties, the government showed passivity and policy of non-intervention, thus only increasing X-es, steaming up the market and pushing stock business of the liberation revolution era to the inevitable collapse. МММ, «Hermes» etc.. However, unlike the Russian, some British companies of XVIII – XIX centuries (mentioned before «saw dust» one, for example) were voluntary giving subscription money back.М. Friedman. Specific attention to expectations was given by the researchers of the new classic macroeconomics R.Lukas, T.Sargent, that added rational expectations to the classic rational behavior of homo economicus. This theory describes passionless economic agent, acting without emotions at the condition of many assumptions (like perfect flexibility of prices and absence of inequality of informational flow to economic agents). As applied to investments field, such approach can be reasonable for institutional investors. But for describing the behavior of small investors Petrazhitsky theory looks more convincing. Thus, the Petrazhitsky theory of optimistic expectations should reclaim its well-deserved place in the history of economic agents’ expectations research.

Thanks to the uncertainty factor, which influence is greatly multiplied during «stock frenzy», the investor (stockholder), according to Petrazhitsky, is mostly driven in his actions by emotions, then by consciousness, and «…every emotional force in its ultimate power can lead to ugly and destructive manifestations, that can make a accidental observer to question intellectual development and even mental health of an actor». In support of this idea, Petrazhitsky cites many authentic examples of establishing of joint-stock enterprises for clearly absurd purposes. Capital stock of such enterprises had been gathered surprisingly fast. It’s important no note, that these examples cover sober-minded and cautious Englishmen. One of the companies set its’ purpose the merging of races…, another one was going to manufacture iron wares from saw dust (after the subscription for «saw dust company» covered the stock capital, the founders announced, that the subscription for the stocks was opened to learn the quantity of fools in London), another subscription was opened «for one perspective enterprise, which aim is yet to be announced…» We can find even more colorful examples, proving Petrazhitsky theory, in the modern history of Russia. It’s enough to recall the episodes of TV commercials of

This particular feature of investors’ behavior during stock boom, highlighted by Petrazhitsky, received attention of other researchers as well. W. Zombart, analyzing the same phenomena in his 1913 work, wrote: «people are spontaneously caught by frenzy, passion, intoxication, negating any rational thought. By reciprocal suggestion, any object… is wrapped by exaggerated conceptions of value and becoming able to continuously rise in price. This rise is a stimulating power, awakening the gambling passion. This passion consequently overgrows primary greed and becomes a single driving source of the mind». At stock market, the greed of the stockholder is multiplied by gambling passion, as denoted by both Zombart and Petrazhitsky.

Petrazhitsky extended the influence of the optimistic expectations law during «stock frenzy» on the founders of joint-stock enterprises, which are often subject to common optimism and, like John Lo, expecting miraculous profits from the companies they are founding. Being sure of the flawlessness of their projects, they perceive themselves as stockholders benefactors. The facts of deliberate deceiving, obvious mystification, which are quite often on stock market, are described by Petrazhitsky as an indirect results of the optimistic expectations of the people. Due to this optimism, the shareholders are ready to be cheated, and swindlers are fast to use this situation.

We should note that Petrazhitsky is not discussing the moral aspects, only defining deliberate deceiving and providing false information about enterprises as definitely immoral. Without getting too deep into debates on the moral aspect of using human passions for commercial purposes, we will note, that lottery business, and exploitation of gambling passion in general should be put close to other passion-driven businesses, brothels and public houses etc..

A creator of a theory is often unable to limit its use to specific field. He has an addictive tend to widen this field. We believe that Petrazhitsky didn’t manage to avoid this path too. He clearly overestimated the influence of the optimistic increase, using it to explain overproduction and origin of economic crisis. Using optimistic increase law as a basis, Petrazhitsky develops two theorems. The first one is about inverse negative relation between optimistic increase and numbers of frauds in stock market crisis. According to Petrazhitsky «the more the pressure of the psychological drive to optimistic increase of stock profits, the lesser is real input of frauds to emerging and explanation of stock crashes and cataclysms.». The second, more sound theorem is supposing direct correlation between the optimistic increase and shifting of the stock enterprises founders away from primary objectives of created companies. The founders of stock companies are becoming more interested in stock operations, forgetting about originally declared objectives.

The expectations of economic subjects and its’ influence at economic processes has been researched before Petrazhitsky (for example, J.G.K.Wicksell) and after him, including J.Keynes and

The modern investment in developed countries surely differs from that of the XVIII, XIX and even the early XX century. Institutional investments are greatly diminishing «emotional component», revealing commonly recognized in modern investments sciences direct correlation of profit and risks. But natural persons, small investors didn’t leave the market and the stock boom (though less evident) occurs occasionally. This means, that the theory of optimistic expectations is still actual. Process of primary accumulation of capital, situations of stock «frenzy», phenomena of arising stock business including situation in Russia at the middle 90-ties of the XX century are described by Petrazhitsky theory quite convincingly.

The law of optimistic expectations has also a deep theoretical meaning, by demonstrating the limited nature of any human economic behavior paradigm. This theory helps to understand the nature of stock market, to realize the threats of unconstrained freedom of founding joint-stock enterprises that brought such negative consequences to the stock market and Russian economics in general at the middle 90-ties of the XX century.

In late XX century American Professor Daniel Kahneman, with Amos Tversky exploring the reasons for the decision-making by investors in a much more developed U.S. stock market late XX century, discovered that they are largely dictated by the optimistic expectations. According to D.Kahneman excessive optimism leads us to “underestimation of uncertainty”. As Petrazhitsky D.Kahneman concluded that the optimistic expectations increase in times of boom in the stock market under conditions of uncertainty and information. In particular, within three years of the boom on the stock market, Professor D. Kahneman observed “a high proportion of investors understand that these” soap bubble “and did continue to invest because they thought that they have a time to withdraw from the market” According to Professor D. Kahneman that our brain is designed to look at not very significant decision with optimism. He even decided to claim that optimism - is the driving force of capitalism, perhaps, is its engine. Thus, almost century later ideas of prominent Russian lawyer, economist, psychologist and lawyer found a new voice, and theory optimistic expectations - a new development.