The godfather of black-swan hedging explains why mounting US debt and the weaponization of the dollar are leading risks today

• Nassim Taleb warns against drawing wrong conclusions from noisy market headlines.
• He criticizes the US for high debt and low growth, leading a fragile financial system.

In life or markets, the first rule of thumb is avoiding ruin. But that can be hard in a noisy world, according to Nassim Nicholas Taleb.

If you read press headlines plagued with risk and uncertainty, and you're not paying close attention to the details, you can end up comparing dissimilar events and drawing the wrong conclusions, he told an audience at The Swedish Residence on Thursday.

Taleb's career in trading led him to conclude that assuming today would be like yesterday is nothing more than betting on randomness and winning on luck. On more than one occasion, he witnessed market crashes that followed strong bullish trends, in which many of his fellow traders lost it all, according to the book "Chaos Kings" by Scott Patterson.

His trading style didn't follow the crowd. Taleb's early success came from buying cheap options that could have explosive upsides from rare events. His contrarian approach allowed him to rake in gains during the 1987 crash, when he had positions in cheap Eurodollar options that benefited from volatility. When the tides turned, he was flipping $2 to $3 contracts for $300 to $500, Patterson wrote. In 1998, it happened again after Russia defaulted on its debt, causing a stock market meltdown. Taleb made money on put options he bought on Russian banks, the book noted.

By 2007, he had enough experience under his belt to publish the book, "The Black Swan," where he popularized the term as a representation of rare, unpredictable events that could have huge impacts, such as 9/11.

From that, a way to measure unpredictability was born that included gray swan events: rare but predictable events like the 2008 financial crisis that showed signs of trouble through the housing bubble.

Then there are fat-tailed events that, in most instances, have normal outcomes, and you don't expect to have huge impacts on markets. But, in one or a handful of data points, the outcome can be so extreme they skew the model. While Taleb didn't coin it, he helped further popularize it. Here, a pandemic is an example of both a gray and fat-tailed event because their outcomes can be tracked, while some can remain local, like ebola, or spread rapidly, like COVID.

Betting on unpredictability

We're familiar with the term "don't panic." It's probably advice you received at some point when things were going off the edge. For Taleb, if you're going to panic, do it early.

When the coronavirus hit, that's what he did. According to Patterson's book, the alarming rate of contagion, coupled with an interconnected planet where global travel was constant, made him conclude that this could get very big, very fast.

Taleb and a team of others published a note on January 26 categorizing the outbreak as an extreme fat-tailed event that could have the risk of ruin because of its non-linear spread. It was almost three months before the US declared a national emergency on March 13 and before the stock market crashed on March 20.

Universa Investments, a hedge fund where Taleb is a distinguished scientific advisor, posted a 4,144% return on the crash of 2020. A bystander could easily assume that the fund, which specializes in profiting from market shocks, turned certain positions on in response to the mounting fears. But that was far from the case. Instead, the firm's flagship tail-risk hedging strategy continually purchases daily put options that could rake in gains in the event of a crash.

Brandon Yarckin, COO of Universa, told Business Insider that as Taleb drafts his academic work around events that don't directly apply to finance, such as Covid, there are corollaries to that thought process that help the investment firm build portfolios. Understanding the interconnectedness and how systems behave in relation to how markets behave is key to that process, he said. In the example of a pandemic, he noted that there are similarities between how diseases spread and how markets crash.

US deficit and the dollar

During the Thursday evening talk, Taleb addressed the US deficit and mounting debt, both of which swelled after the pandemic.

He highlighted the four categories of debt-based countries: those with low growth and high or low debt, and those with high growth and high or low debt. The US is in the category of low growth and high debt. The issue, he said, is that debt isn't made for large mature economies, which is where it's usually found most.

This is because the growth trajectory tends to follow the S-curve pattern: slow, then rapid, then leveling off. You don't need to continue growing once you're on top of the curve. However, if a country accumulates high debt, then continued growth is required to absorb it, he noted. The outcome is a fragile leveraged financial system with increased interconnected risk, which is the US' current predicament, he added.

Taleb emphasized that government expenditures aren't purely to blame. The US is stuck with accumulating debt-servicing costs, and it's now spending more on interest payments than military spending. This is creating a snowball effect, where it must keep borrowing the difference. At present, Taleb doesn't believe that the ballooning debt could be solved politically or by increased demand for US bonds.

Mark Spitznagel, Universa's founder and CIO, previously told Business Insider that the mounting credit bubble could lead to a massive stock market crash that could be worse than 1929.

As for the US dollar, for the most part, people like to transact with it because it's a stable currency, Taleb said. The real question is whether they use it as a store of value. Here, Taleb believes, is where the problem lies. The big question he asked the audience is, "How safe do you feel putting your money in Western banks?"

From his perspective, not very safe. Since 2022, the financial and monetary systems have been used as a foreign policy tool, he said. Bank accounts and assets of Russian subjects have been frozen based on their political ties. Taleb believes that this type of behavior harms the US dollar long-term.