I'm pretty sure they made it about performance, not capacity.
Flash = no seek and load times, much increased durability.
It has better durability and is slightly faster (iPod hard drives are by no means slow) but at a greater cost of capacity! The biggest selling point Apple could have had was that the touch was THE definitive video player, but with little capacity that can't happen. It also would have separated it from the iPhone. Flash is great, but for another few years when capacity is no more than a sneeze, I'll take a hard drive anyday.