Let's say that in the counterfeiting example, the counterfeiters pumped $300 billion a year of counterfeit bills into the economy. The counterfeiters spend all this money on wine and women.

When the counterfeiters are found out, this $300 billion dollars of demand for the vineyard and brothel industry evaporates. That will cause much unemployment. I agree with you that this should be allowed to happen. The workers in those industries must find new jobs that are economically productive. The government should not step in and start printing money to prop the brothels up, as this will simply create zombie industries as Giles noted. (Nor can the Giles recover the lost wealth - the counterfeiters already spent the money, the resources that went into producing the wine and woman have been consumed).

But there is a second cause of unemployment, which is the unnecessary collateral damage caused by the deflation. When half of the money supply evaporates, people's savings to expenses ratio are now at dangerously low levels. So they start reining in expenses. But all expenditures are another person's income, so business revenues fall. In theory, the businesses could drop their wages and prices an equivalent amount, and eventually you would get a pigovian rebalancing effect. But the trouble is sticky labor and, more importantly, debt contracts. When revenues fall, the businesses cannot pay debts, they go bankrupt, people are unemployed, and you get a full fledged deflationary spiral. Millions go unemployed, not because they were not building something people wanted (they were), but simply because contracts rely on a steady money supply, and when money supply drops by 50%, all contracts get shot to hell.

There are two solutions: one, the government could announce that in light of the discovery of the counterfeit bills, all contracts will be redenominated at a 2:1 ratio - thus debt contracts will be cut in half, wage contracts cut in half, NFL salary cap cut in half, leases cut in half, etc. Or, the government could announce a one month window in which people can trade in their counterfeit bills for real ones. This will restore the money supply to the original levels. Either one of these solves the problem instantly and completely avoids the depression. There are no zombie industries, everyone just continues with their productive pursuits. The only unemployed people are at the vineyards and brothels, they must still find new jobs.

Of course, if the government decides to restore the money supply by printing money and giving it to government workers digging ditches, then you will still get massive frictional unemployment, and you'll permanently reallocate resources into useless activities. This is the Keynesian/Obama solution and it's a terrible one.

The problem you, Giles, and the Austrians have is that you do not distinguish the unemployment caused by necessary restructuring ( the brothels and vineyards) from the unemployment caused by a fall in the money supply and the wrecking of contracts. The first cannot and should not be avoided. But you can, and should, prevent the collateral damage that creates a great depression. Until you see the difference between these two types of unemployment, you guys will get killed in debates with the Keynesians, and no one will listen to you. Which is too bad because the Austrians have a lot of great insights, and the Keynesians are awful on a lot of other points.