I think the smaller cloud based iphone isn't going to happen. If you watch Steve Jobs talk in his interview with Bill Gates on All Things D, Steve says that client based coupled with cloud data is better than completely cloud based.
This rumor that a smaller iphone with no real storage and apps based in the cloud i think is not going to happen. There's too much to unreliability with bandwidth and data connection to factor in. Steve seems confident that powerful cloud databases being accessed by client stored applications is the way to go.
figured that much. Yes, a free iPhone would be nice to most people.. but it wouldn't be a true iPhone. Now, a cheaper iPhone in general.. is most likely.