[bigpics]

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Relevance to this discussion: chic and new and attention-grabbing products sell more than pure functionality. Again part of why there's no HDD iTouch.

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Your hypothesis doesn't make a lot of sense, because the Touch has more pure functionality than a 160GB iPod. You can browse the web on a touch! That's functionality, baby. Wheras increased storage capacity doesn't add much in the way of functionality for most users. Very few people would listen to 160GB of music between syncs. In fact, that would be impossible, as the battery would not last long enough to play anywhere near 160GB.
So, really, the added functionality of such large amounts of storage is very minimal, unless you have some very specific needs. I have a huge music collection on my Mac, but am perfectly happy with a 4GB Nano. Smart playlists and podcasts do everything I want. I have no need to carry my entire collection around with me - but browsing the web and buying tracks while I am mobile are attractive features. I also enjoy the smaller form factor. HD based iPods have always been too large.

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Actually that sentence post can be interpreted as you did -- although it should be abundantly clear in context from the whole post that I'm recognizing the extra iTouch functions as highly desirable and useful -- just as storage is a useful function for those who will use it.
And that my thrust is that many of the people who will fully utilize the iTouch functions are the same ones with high storage needs. Thus Apple could have taken the slightest of chances and given us those combined functions in one model the size of the classic, even at the cost of reduced battery life (reduced primarily only for video).
The "chic" and whiz-bang comment is based on the fact that many will buy for novelty and to have the latest tech gee-gaw and will only marginally exercise the full capabilities of this amazing (memory constrained) machine.
When you (echoing the practice of many here) say "HD based iPods have always been too large" as an absolute you're leaving out the "for me" part you really mean. The question is actually of course "are HD-based iTouches too large to sell enough of to make a satisfactory profit for Apple in terms of its whole customer base.
I think they well might be, and would rather have seen one Classic model (or none) and 3 (or 4) iTouches, one (or two) HDD-based. Dollars to donuts says the Classics will be the slowest selling of the new line, being neither compact nor full-featured. I don't how much Apple determines their products from sales/user behavior studies and how much springs from the head of Steve and Co. like a goddess from Zeus' forehead, but in either case I think they missed a trick.
And they do occasionally. A few hours after a number of us posted that Apple could have avoided a flap by issuing something like $100 in ITMS creds to initial iPhone buyers, the Stevester belatedly recognized that indeed this made a great deal of sense and probably acted fast enough to avoid permanent ill-will, but it WAS easy to see coming.
This other misstep though, I don't expect to see corrected, and those of us who do want both a real jukebox and a convergence device will either have to wait another year for 32GB (or hopefully 64, my minimum needs), or in my case, keep my 5.5 alive and use my iTouch 2 for day trips without lugging my notebook around. So another year of lugging and thinking "how close but yet so far."