I've never tested it, but with this setting, does Auto Import really REMOVE files automatically from your library if say your network went down for a while? I would've hoped that MC's inability to communicate with a network drive (or equivilent device) at all for a period of time is much different from detecting that a watch folder or it's contents have been deleted.
I have tested it and yes, it does. However, I only had the issue occur when starting up MC with the option set to yes and my USB drive disconnected (it was on my laptop and it was an oops but not a huge one). I don't know if the auto-running Otto would have been so efficient (had I disconnected the drive while MC was open) but I suspect it would be much the same. Perhaps it would be slower though, since it might not "detect" the change (when MC starts up, it does a semi-manual Auto-check), I'm not sure on this...
To the OS (and to MC) there really is no difference between the file being deleted and the file just being missing. Perhaps MC could check to see if the drive was accessible at all and then not remove the files if not, but this would add overhead and frankly, that's what option #2 is for.
and on a similar note, how do you do this if you're NOT using Auto Import?
i.e. if you externally deleted files that were in the library, how do you get MC to remove them from the library?
Simple. The option still applies to manually initiated Auto-Import runs. Simply configure the option as desired and then when you want to remove the files, do a Tools --> Run Auto-Import Now. This has not changed from MC11.1, only the place where it was configured and initiated was modified a bit.
Quite often, if I have a lot of files that I need to remove from MC that happen to live on a network drive or something similar, I'll make darn-well sure my network drives are all connected and working, backup my library, and then switch the option to #1 (Yes) and run a manual scan. Afterwards, I immediately switch back to option #2.
Generally I just delete or move files from within MC, but sometimes it happens and I need to fix MC's library to match!