The Federal Reserve Board's attempts to control credit demand by letting interest rates move freely and to combat inflation by restraining the money supply are misguided, according to a paper published today by the Brookings Institution and written by an economist who has worked for many years in New York financial markets.

Albert M. Wojnilower argues that business cycles are restrained only by a "credit crunch" or drying up of the supply of credit. If only the price of credit -- i.e., interest rates -- is constrained, then people go on demanding it, he says in one of the papers published in the latest issue of the "Brookings Papers on Economic Activity."

After each credit crunch, the financial markets adapt to try to avoid being caught the same way again, while the Fed has tried to change its methods of restraint to avoid precipitating crisis, Wojnilower claims. Over time the Fed has shifted towards less and less regulation of financial markets, in the expectation that letting interest rates rise freely gradually would choke off credit demand.

But it would require extraordinary and unacceptable increases in interest rates in order to slow credit expansion in an unconstrained financial market, the economist and banker argues. He does not provide a formal frame work for his thesis, but gives a history of the various credit crunches since World War II and the financial system's response to them.

He says this shows that "credit crunches caused by regulatory constraints on the financial markets have played a constructive role in precipitating cyclical downturns ahead of more serious endogenous bankruptcy crises . . . and before the high inflation rates characteristic of business cycles could become deeply embedded."

He believes, moreover, that the shift in money policy to controlling the monetary aggregates, in particular the narrow M1 measure of the money supply, has been a shift toward eade and encouragement of higher inflation and interest rates.

The links between any credit measure which the authorities are trying to control and economic aggregates such as the growth of nominal gross national product tend to break down once the Fed tries to control the aggregate, Wojnilower says. This idea has been propagated by Charles Goodhart, an official of the Bank of England, and has become knows as "Goodharths law." Wojnilower restates it succinctly as "any variable the central bank chooses to control automatically becomes irrelevant" as the ingenious financial markets work out a way of circumventing it.