Tuesday, July 23, 2019

Monday, July 22, 2019

India urban real estate facts of the day

Real estate speculation is among the greatest macroeconomic risks that developing countries like India should watch out for. Episodes of economic growth and credit booms are invariably accompanied by real estate booms, especially in developing countries. And financial market deregulation only exacerbates the risks. 

Joe Studwell's excellent book on Asia chronicles the South East Asian experience with real estate resource misallocation and how it adversely impacted economic growth and exposed those countries to macroeconomic instability from both internal and external sources.  

Sample a few snippets from an FT article on India,
30 per cent of real estate projects and half of all built-up space in Mumbai is under litigation, according to a 2019 Brookings India report, with projects taking an average of eight and a half years to complete.
And this is only the latest in inventory pile-up that has been a feature of India's metro property market for years now,
Property consultancy Anarock estimates that half of the luxury real estate in Mumbai’s downtown alone is unsold: 11,000 properties worth a total Rs590bn... Unsold inventory in the city rose 14 per cent in the first half of 2019 from the same time a year earlier, according to Knight Frank.
And the role of shadow banks,
Shadow banks grew to account for a fifth of all new credit last year, and became the largest source of funding for real estate thanks to loan growth of more than 20 per cent a year between 2013 and 2018.

Saturday, July 20, 2019

Weekend reading links

1. This is a long list of recommendations to reform the start-up eco-system in India. Two observations. One, the author seems to obsessed by reduction in taxes and provision of incentives. Almost all the proposals belong to either of these two categories. Two, the entire onus on creating start-ups is with the governments.

Reading articles like this, one almost gets the impression that start-ups are a new entrant into business landscape, start-ups are always about innovation, and economic growth is critically dependent on such innovative start-ups. This has almost become an entrenched narrative.

But in reality, all the three impressions are flawed. Business entry and exit are commonplace, and millions of new enterprises enter the market each year in India. The vast majority of them are not about any innovation, but plain simple trading, manufacturing, and services businesses, mostly self-employed or with a couple of employees. While these start-ups are critical for the long-term productivity trends in the economy, short- and medium-term economic growth is mostly about the plain vanilla economic activities.

2. Blackstone awaits an economic downturn in the winner takes all market,
The firm announced on Thursday that assets under management had reached a staggering $545bn, after taking in $150bn in the last 12 months. Firms like Blackstone do best when they can chase opportunities in an economic dislocation. In this respect, Blackstone may be eagerly awaiting a downturn... Blackstone’s fundraising haul once again reinforces the winner-take-all paradigm in alternative investments. It has raised money of late in private equity, credit, and real estate. The big pools of capital like sovereign wealth funds are putting more money in alternatives but working with fewer managers. One-stop-shops like Blackstone disproportionately benefit. In the past year, Blackstone took home $1.6bn in earnings from management fees before any incentive “carry” is accounted for. This year, Blackstone’s shares are up more than 50 per cent.
3. FT on why British civil service feels shaken by the politics surrounding Brexit. Brexiters feel that the civil service is putting up obstacles to an exit, and feel that it has become politicised. Surprising that a civil service often considered the touchstone for neutrality and has survived many such political cataclysms is becoming so embroiled in the Brexit politics.

4. Apollo Hospitals seeks foreign capital. As I have blogged earlier, this is in line with the trend of foreign capital entering India's tertiary care market with attendant undesirable commercialisation and profiteering in health care practices.

This intrigues me. In the landscape of economic activities, given the stage of India's economic development, tertiary health care has to be among the most promising of investment destinations. And Apollo is perhaps the leading healthcare brand in India. Why isn't Apollo able to attract Indian capital? Or do they want foreign capital for some reason? Or do the Indian investors realise that perhaps Apollo is not after all a good investment? Or does this convey the lack of depth of Indian capital available for investing in even areas like tertiary healthcare and a brand like Apollo? Or does this reflect corporate governance and management capabilities within Apollo itself?

5.  Nice article on the turmoil facing the US Federal Reserve.

6. Fascinating chronicle of the lives of millennial generation working-class people from different parts of the world in Bloomberg by Vauhini Vara - seamstress, street vendor, abalone poacher, marijuana grower care giver, warehouse picker, computer reseller, electronics maker, social media influencer, and call centre manager.
Decent jobs are flowing to big cities, with millions of workers leaving their ancestral towns in anxious pursuit, often slipping past national borders to do so. The internet is exposing people not only to opportunities that were once out of reach, but also to the unsettling knowledge that other people have many more. And the stories confirm that to be working class is, by and large, an insecure state. Superiors view labor as replaceable. Speaking publicly about one’s job can invite reprisal from an employer—or a government.
7. Global distribution of artificial intelligence talent shows India at third place, closely behind China.
8. Finally, ending with startups, Bloomberg compares the startup scenes in India and China. While China has 94 unicorns, India has just 19. The largest Chinese unicorns offers services with bitcoin, drones, and robots, whereas the four largest Indian unicorns are in consumer facing online payments, e-commerce, ride-hailing, and education. 
It’s not surprising, then, that nine of India’s top 10 unicorns by value are in the online-consumer space, according to data compiled by CB Insights. The outlier is ReNew Power, an independent wind and solar-energyproducer. In China, three of the top 10 are online consumer companies, two are bricks-and-mortar businesses, and the rest are a mix of hardware and B2B.
9. Finally, very good article on Novak Djokovic.
Novak Djokovic has a way of winning even when he’s losing. He has a way of patiently absorbing his opponent’s most devastating play, doing just enough to stay alive, and choosing precisely the right moment to strike back. He’ll lose a spectacular rally and then, while the commentators are still gushing about the other player, unspectacularly win the next point.. He’s as capable of spectacular dominance as any player who’s ever lived... He can hit shots that make you think your TV is a liar. But it’s that other mode, his dark mode of tactical endurance, that makes him the most fearsome tennis player of the past decade and possibly the most fearsome of all time. He’s a genius at operating within bad runs in such a way as to give himself the best chance of seizing key moments... In just about every category imaginable, Federer was the better player, and he lost... Federer dominated the game of runs but couldn’t keep Djokovic from seizing control of the game of moments... It was tight, brutal, unpoetic tennis with no margin for error, and he pulled it off.
This comparison of Federer and Djokovic,
Everywhere Federer goes, the crowd adores him; he’s played out the whole endless twilight of his career with a permanent home-court advantage such as no other player before him has ever experienced. When he’s winning, the crowd shares and magnifies his joy; when he’s losing, fans will him to come back. There’s a net under him as well as across from him; he plays every match with a buffer of emotional support. Now consider how things are for Djokovic. He wants that kind of love, and almost never gets it. When he wins Wimbledon, and struts forward, smirking, to make the crowd watch his excruciating grass-eating bit, the applause is … polite. Before then, nearly everyone in the stadium, and nearly everyone watching at home, millions of people around the world, were praying for him to lose. The player who most covets affection is the player from whom the crowd most stubbornly withholds its affection... He knows how to stay calm and play smart when he’s being outplayed because he’s used to feeling that things aren’t going his way. He knows how to capitalize on a match’s moments of crisis because he is in a perpetual state of micro-crisis. He’s learned to rely on himself because he can’t rely on the crowd.

Thursday, July 18, 2019

The birth pangs of India's IBC continues

I had blogged earlier here, here, here, and here about the challenges facing the fledgling Insolvency and Bankruptcy Code (IBC) due to competitive litigation by competing creditors and buyers.

Last week the National Company Law Appellate Tribunal (NCLAT) dismissed a plea challenging Arcelor Mittal's elgibility to buy Essal Steel India Ltd. The latter had argued that the bid was ineligible under Section 29A of the IBC, whereby bidders cannot be connected to other defaulting parties. The NCLAT ruled that this was already settled by the Supreme Court earlier on 4 October, 2018 and therefore cannot be re-litigated.

It also ruled that its operational creditors, consisting of vendors and suppliers, were to be treated in an "equitable manner" with secured financial creditors at the time of settling claims. It ruled that lenders and operational creditors would get 60.7 per cent of their outstanding claims and proportionately share the Rs 42,000 crore that Arcelor Mittal has offered to pay. The resolution plan, approved by the Committee of Creditors (CoC) which does not contain the operational creditors, had proposed a small share to operational creditors and 92.5 per cent to financial creditors.

This ruling equating different creditors effectively makes secured, unsecured, and operational creditors on a par. Secured creditors have understandably expressed their concern and are planning to appeal before the Supreme Court. It also discourages banks from taking companies to IBC and prefer liquidation which would only destroy value. 

This interpretation by NCLAT is in keeping with the practice of imposing judges' subjective preferences and values in judicial pronouncements. Latha Venkatesh summarises the problem nicely. This on the IL&FS case,
In the IL&FS case, the NCLT has indicated that provident funds, even if they are not secured or senior creditors, should be given their dues at par with or even over secured creditors because the beneficiaries of these funds are more vulnerable due to their age. In the Essar Steel case, the NCLAT set aside the distribution that the committee of creditors (the CoC) put forth. The CoC, in keeping with clause 30 (2b) of the Insolvency Code, gave 10 percent to the operational creditors and kept 90 percent for themselves, i.e the secured creditors. The NCLAT cancelled this plan and ordered the CoC to give 40 percent to the operational creditors on the ground that the CoC and the NCLAT are bound by a higher law of fairness. The Clause 30 (2)(b) of the IBC says that operational creditors need to be given liquidation value, and once the CoC gives a plan that satisfies this clause the NCLT, under Section 31 “shall” accept the CoC’s plan.
Let us cut through the legalese, to where the two cases meet. The IBC and commercial law, in general, are predicated on the premise that those creditors, who have given loans in exchange for a collateral or security, should be paid before those who have given unsecured loans. The difference is reflected in the interest rates. World over, secured loans attract lower interest rates while unsecured loans bear a higher interest. This is because low risk in secured credit gets a low return, while unsecured loans are high risk and hence get a higher return. This fundamental principle of commercial law has gotten dislodged in the above two cases.
In the IL&FS case, the tribunal is moved by sentiment towards one group of lenders. But such a judgement can hurt the entire economy and cause untold misery to the entire country. If the fund manager of the provident fund has been reckless and subscribed to debentures that are substandard, while bankers have been smart enough to “secure” their credit, the mere fact that the PFs beneficiaries are more vulnerable cannot be used to override the rights of secured creditors. If this became law (as all precedents do), then the concept of secured credit will be undermined and all banks will give only unsecured credit and charge high rates to make up for the risk. Bankers may go a step further and even demand that if a project needs their loans, the borrower must promise never to take loans from provident funds.
And this on the Essar Steel case,
Here, the NCLAT has done two things which may upset the economic applecart.

1) The IBC has given more powers to the CoC to draw up a resolution plan since they are the biggest lenders and their help is needed for the future survival of the company. The CoC is directed by the IBC to follow a prescribed waterfall: first the legal dues to employees, then secured creditors after 10 percent liquidation value to operational creditors. The NCLT was intended to ensure the process has been followed, not substitute its commercial judgement in place of the CoC’s. By setting aside the position of the CoC, the Essar judgement can destroy the entire edifice of the IBC, since creditors and the resolution applicant will be willing to go ahead with a plan to rescue a company only if it makes commercial sense to them...
2) The Essar Steel judgement of the NCLAT also in a way gives almost as much importance to the operational creditors as to secured creditors. Like in the IL&FS case, this can jeopardise the entire credit system in the country, with all creditors preferring to give unsecured loans at high interest rates, thus grinding all economic activity to a halt. The law gives operational creditors liquidation value with a reason. An operational creditor is only exposed to one production cycle and, if not paid, the creditor stops supplying. The secured financial creditors, viz the bankers have taken a risk on the company for many years, betting its plant will be set up and bear profit over time. Commercial law, everywhere, gives such creditors more powers. Else, no one will fund expansion plans or greenfield projects. Some experts have argued that in many small companies operational creditors bear the entire risk in the form of suppliers credit and hence they need to be given a fair share when the stressed company is sold. They have a point which perhaps needs to be addressed. However, while addressing operational creditors, the law needs to note that in many cases operational creditors are related parties: In Essar Steels case, over 20 operational creditors are group companies. If the NCLATs order becomes law, then all promoters, who see their companies in danger of going into IBC, may quickly create bogus operational credits with group companies. The NCLAT's judgement can thus lead to perverse developments that hurt the larger good.
I had blogged earlier highlighting that among the biggest concerns about the success of the IBC came from the judiciary. This is only the latest example of how judicial activism or kritarchy of the wrong kind can have damaging consequences in distorting incentives and imperilling the effectiveness of public policy.

Fortunately, despite these intemperate decisions, like with the GST, the Ministry of Corporate Affairs seems to be swift in reacting effectively to such emergent scenarios. The Union Cabinet yesterday has passed several amendments to the IBC with the objective of addressing the problems that have emerged from the likes of Essar Steel case and attendant court judgements.

The amendments aimed at speeding the bankruptcy resolution process include enforcement of a strict 330-day timeline for the insolvency resolution process, including the time taken for legal challenges (the courts had started excluding this time in the 270 day time limit given under the Code for approval of the resolution plan); upholding secured creditors' priority right on the sale or liquidation proceeds; making clear the rights of financial (who have not voted in favour of a rescue plan) and operational creditors; specifying that the resolution arrived at the IBC is binding on central, state and local governments etc.

This is a good example of the iterative approach to ensuring effective implementation of complex regulations and commissioning of large projects. As I have written earlier, I am very impressed by the vigilance exercised by the Ministry of Corporate Affairs over the past two years of IBC and the swiftness with which it has stepped in on multiple occasions to address emergent failings/flaws exposed in the legislation and its regulations.

Someone should write a case study on the implementation of the IBC Act. It can be a rare good illustration of high quality state capacity, and yet another example of how corporate India and the judiciary loses no opportunity to distort every new law that comes their way.

Tuesday, July 16, 2019

Oped on financialisation of world economy

Here my co-authored oped in Livemint today with Anantha on financialisation of the world economy, a short summary of the book, The Rise of Finance, itself.

Monday, July 15, 2019

The Wall Street tail wags the monetary policy dog

The Fed Chairman Jerome Powell's ill-advised testimony to the Congress early this week and the market's reaction reflects several features which characterise the Fed and Wall Street.

Despite signatures to the contrary (or atleast be less alarming), including a strong June Jobs report and a truce in the trade war with China, Mr Powell repeatedly said that the Fed was committed to preventing a slowdown in US expansion,
“Economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the US economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent than we currently anticipate.”
This is perhaps the most craven example of the Fed being bullied into submission by the President. It should put to rest all the talk about Fed's independence. Sad, since Powell started out with so much promise.

And, as has become typical of the markets in responding to such announcements, the yield curve dived dramatically,
Clearly, there is no reasonable explanation - theory or change in conditions - for this level of decline. It only re-affirms the unique psychology of the markets - overshoot and undershoot in response to transient news, and as the bubble inflates the magnitudes of these shifts only increases.

And, this excessive shift in turn hardens expectations and sets in motion another set of self-fulfilling dynamics. And the expectations from the next FOMC meeting end of this month naturally gets baked in. The result is that the Fed's monetary policy decision becomes a case of the dog wagging the tail. Sample the reactions from the market that highlights the shaped expectations,
“There is really no good excuse for cutting rates at all,” said David Kelly, chief global strategist at JPMorgan Asset Management. “They’re doing so to avoid a market meltdown.” Seema Shah at Principal Global Advisors said: “The Fed is cutting rates not in response to the economy, but in order to avoid a market fallout . . . The Fed put itself in a corner. We’ve had a run of stronger data which at any other time would not have led them to cut rates.”

Saturday, July 13, 2019

Weekend reading links

1. The disconnect between rising executive compensation and declining shareholder returns continued in 2018. WSJ writes,
The chiefs of banking and financial institutions in the S&P 500 received a median raise of 8.5% last year, compared with 5.6% for CEOs in the broader index, according to a Wall Street Journal analysis. Meanwhile, firms in the sector posted a median total shareholder return—or stock-price changes plus dividends—of negative 17% in 2018, while the median return for the index as a whole was negative 5.8%. Median pay for finance CEOs was $11.4 million for the year, $1 million below the overall S&P 500 median. The Journal analysis uses total compensation as specified by Securities and Exchange Commission regulations, which includes salary, annual bonuses, and long-term equity and cash incentives. It also includes perquisites and the value of pension gains and some increases in deferred compensation accounts.
2. Fascinating chronicles of the debt-driven growth and fall of self-made corporate empire builders in China. For decades, the scorching pace of economic growth masked the pitfalls of debt accumulation and aggressive expansion into over-crowded and unfamiliar sectors. The country's overall debt quadrupled over the past decade, with corporate debt forming two-thirds.
Corporate bonds outstanding has exploded from negligible baseline a decade back to $1.72 trillion outstanding as of end-2018, coming second to the US companies which carried $5.81 trillion. And since the government initiated measures to control excessive lending in 2017, including allowing companies to fail by asking lenders not to restructure, there has been a rise in corporate bankruptcies,
Now with the economy slowing and government taking steps to dial-down excessive lending, more stories like this are emerging,
When she was a teenager in the 1970s, Zhou Xiaoguang peddled trinkets city to city and slept on trains, a formative chapter in her creation of the world’s largest costume jeweler, Neoglory Holdings Group Co. Leveraging her empire of baubles, China’s “fashion-accessory queen” added hotels, offices and malls. The magnate took a seat in China’s national parliament, accepted business accolades, including Ernst & Young’s “Entrepreneur of the Year,” and erected the tallest skyscraper in Yiwu, a trading city south of Shanghai... Neoglory fueled its evolution into a conglomerate through expansive borrowings, which ballooned to $6.8 billion, even as financial filings show cash was tight and profits were weak. Behind the scenes, the company was taking on new risks to borrow, including ever-shorter payback schedules. The troubles burst into view in mid-September when Neoglory defaulted on a bond payment. Several more defaults followed... Neoglory said it embarked on a rollout of retail outlets when online selling was more promising, and it overbuilt real estate in undesirable locations...
Ms. Zhou has attributed her entrepreneurialism to a hardscrabble upbringing near Yiwu when the area was rural: Lacking shoes as a teen, she made a pair; to save money on trips to sell embroidery, she took night trains. She set up a sales booth in 1985 in Yiwu, and Neoglory began production in 1995. Inside a decade, Ms. Zhou was the richest woman in Zhejiang province and a symbol of the country’s breathtaking industrial rise. She and other exporters made Yiwu a global giant in low-price merchandise. The trading city is centered on a vast complex that snakes along 4 miles where wholesalers sell goods, from socks to Christmas ornaments. Neoglory necklaces and earrings sell around the world, including on Amazon.com Inc. and at J.C. Penney Co. in the U.S., often fitted with crystals from Austria’s Swarovski AG. Ms. Zhou built a massive factory compound that included apartments for her family and quarters for employees, at one point numbering 7,000. “The whole industry in Yiwu was brought up by her,” said Wang Wei, a former Neoglory employee who owns one of the 4,500 costume jewelry shops in the city’s wholesale center.
Such stories raise the question of whether such excesses and pain are inevitable accompaniments of spectacular growth episodes.

3. The future of retail check-outs being tried out by Tesco - swapping cashiers for cameras.
4. If you thought big-tech was about intangibles like intellectual property and less about hardware, think again. Bloomberg points to the physical infrastructure like computer networks and logistics machines that they command, which raises enormous entry barriers, or "moats",
For all the claims that Amazon copies hot-selling products sold on its websites, or unfairly uses data about shoppers’ purchases and searches for its own ends, it is Amazon’s network of warehouses and its ever-expanding logistics machine that give it an advantage few competitors can match... Amazon isn’t alone in widening its moat. Last week, Alphabet Inc.’s Google announced the latest privately funded undersea cable between Europe and Africa. That kind of infrastructure used to be built by consortia of telecommunications providers, but it has become common for Facebook, Microsoft Corp. and Google to go their own way. This year, Google has saidit will spend more than $13 billion just in the U.S. on data centers and other real estate... In the last 12 months, the five biggest U.S. technology companies recorded nearly $90 billion of combined capital spending — big-ticket item such as computer data centers, internet cables, specialized equipment to build computer chips, warehouses and other real estate.

5. UK accounting watchdog, Financial Reporting Council, is scathing in its indictment of the big auditors in its annual report in a year marked by high-profile accounting scandals at companies like Patisserie Valerie and Carillion,
The Financial Reporting Council warned of an “unsatisfactory” deterioration in inspection results for PwC’s audits of FTSE 350 clients over the past year, after only two out of three of the audits scrutinised met the watchdog’s standard of needing only limited improvement. That was a steep decline from the 84 per cent which passed the threshold the previous year. But the watchdog’s sharpest criticism was reserved for the Big Four’s smaller rival Grant Thornton, which served as the auditor for Patisserie Valerie when a multimillion-pound black hole was discovered in the cake shop’s accounts last year... Grant Thornton now faces heightened scrutiny from the watchdog after only 50 per cent of its audits were found to meet the FRC’s standard, down from 75 per cent in the previous round of inspections... None of the seven firms surveyed — which included BDO and Mazars as well as the Big Four and Grant Thornton — met the FRC’s standard for 90 per cent of their inspected audits to need only limited improvements. The FRC examined a sample of audits for each firm. In every firm, the watchdog found cases where auditors had failed to be tough enough in challenging management on questions of judgment.
6.  The case for private management of many infrastructure projects stands on questionable foundations,
Whereas EDF’s current nuke under way at Hinkley Point in Somerset requires a weighted average cost of capital of 9.3 per cent, if you permitted the EDF tax (known in polite society as the “regulated asset base” model) with the next one at Sizewell, then that could fall to 6 per cent. What it doesn’t do is beat state finance. The UK government’s cost of borrowing is less than 2 per cent. So why do it this way? 
One classic answer is that the state just cannot borrow all that money. Pile too much on the public sector borrowing requirement and there might be a gilt buyers’ strike. Another is that the private sector brings a magic ingredient: that of extra efficiency. Those dividends can all be afforded through the savings on capital and operational costs that entrepreneurial managers bring. Both claims are suspect. Let’s take the second first; the one about efficiency. It is difficult to find compelling evidence. For instance, England’s private water companies are no more efficient than Scotland’s state-owned one, according to a 2011 assessment by the regulator, Ofwat. That’s despite being privatised 30 years ago. As for finance, there’s surely a distinction between selling bonds to fund current spending, and doing so to create real assets with attached revenues. If you think about it logically, it’s hard to see why a properly constituted national infrastructure fund with its own balance sheet — backed by highly rated assets — couldn’t finance itself at fine rates.
This and this are a good summary of the sophistry and valuation gimmicks that the industry is resorting to in the backdrop of Labour's plans to renationalise water if elected to power. This is a very good case against the industry demand for market valuation and in favour of the regulated capital value (RCV).

7. An emerging natural resource scarcity is that involving sand,
Roughly 32 billion to 50 billion tonnes are used globally each year, mainly for making concrete, glass and electronics. This exceeds the pace of natural renewal such that by mid-century, demand might outstrip supply (see ‘Global scarcity’). A lack of knowledge and oversight is allowing this unsustainable exploitation... Desert sand grains are too smooth to be useful, and most of the angular sand that is suitable for industry comes from rivers (less than 1% of the world’s land)... Most of the trade in sand is undocumented. For example, between 2006 and 2016, less than 4% of the 80 million tonnes of sediment that Singapore reported having imported from Cambodia was confirmed as exported by the latter. Illegal sand mining is rife in around 70 countries, and hundreds of people have reportedly been killed in battles over sand in the past decade in countries including India and Kenya, among them local citizens, police officers and government officials.
This graphic of sand mining and attendant water flow patterns is striking.
8. Germany's debt-to-GDP ratio is set to drop below 60% this year, and that is a cause for concern regarding the supply of German bonds, bunds. 
If there are not enough of them around, banks could run short of high-quality collateral for lending, while the European Central Bank will struggle to find enough bonds to buy if it wants to revive its quantitative easing programme to combat a downturn... “By the mid-2030s there is a very plausible scenario where German government debt has almost entirely disappeared,” said Christopher Jeffery, a fixed-income strategist at Legal & General Investment Management... For markets, however, there are some uncomfortable implications. Banks rely on a ready supply of highly rated government debt to use as collateral for lending. But the amount of such debt shrank dramatically during the crisis, thanks to a slew of downgrades from credit rating agencies. According to a speech earlier this year by ECB executive board member Benoît Cœuré, triple A-rated sovereign debt in the eurozone amounts to just 10 per cent of GDP, compared with 70 per cent in the US.
9. Inculcating basic literacy and numeracy is just so hard. Sample this from American early grade classrooms,

American elementary education has been shaped by a theory that goes like this: Reading—a term used to mean not just matching letters to sounds but also comprehension—can be taught in a manner completely disconnected from content. Use simple texts to teach children how to find the main idea, make inferences, draw conclusions, and so on, and eventually they’ll be able to apply those skills to grasp the meaning of anything put in front of them. In the meantime, what children are reading doesn’t really matter—it’s better for them to acquire skills that will enable them to discover knowledge for themselves later on than for them to be given information directly, or so the thinking goes. That is, they need to spend their time “learning to read” before “reading to learn.” Science can wait; history, which is considered too abstract for young minds to grasp, must wait. Reading time is filled, instead, with a variety of short books and passages unconnected to one another except by the “comprehension skills” they’re meant to teach. 

As far back as 1977, early-elementary teachers spent more than twice as much time on reading as on science and social studies combined. But since 2001, when the federal No Child Left Behind legislation made standardized reading and math scores the yardstick for measuring progress, the time devoted to both subjects has only grown. In turn, the amount of time spent on social studies and science has plummeted—especially in schools where test scores are low. And yet, despite the enormous expenditure of time and resources on reading, American children haven’t become better readers. For the past 20 years, only about a third of students have scored at or above the “proficient” level on national tests. For low-income and minority kids, the picture is especially bleak: Their average test scores are far below those of their more affluent, largely white peers—a phenomenon usually referred to as the achievement gap. As this gap has grown wider, America’s standing in international literacy rankings, already mediocre, has fallen... All of which raises a disturbing question: What if the medicine we have been prescribing is only making matters worse, particularly for poor children? What if the best way to boost reading comprehension is not to drill kids on discrete skills but to teach them, as early as possible, the very things we’ve marginalized— including history, science, and other content that could build the knowledge and vocabulary they need to understand both written texts and the world around them?...
For a number of reasons, children from better-educated families—which also tend to have higher incomes—arrive at school with more knowledge and vocabulary... As the years go by, children of educated parents continue to acquire more knowledge and vocabulary outside school, making it easier for them to gain even more knowledge—because, like Velcro, knowledge sticks best to other, related knowledge. Meanwhile, their less fortunate peers fall further and further behind, especially if their schools aren’t providing them with knowledge. This snowballing has been dubbed “the Matthew effect,” after the passage in the Gospel according to Matthew about the rich getting richer and the poor getting poorer. Every year that the Matthew effect is allowed to continue, it becomes harder to reverse. So the earlier we start building children’s knowledge, the better our chances of narrowing the gap.