Gwyn --
Masterfully done. I will respond at greater length when I have time to do so properly. For now, I will respond with a couple brief observations.
First, the "they live in another sim" argument is actually more forceful than your strawman. This difference is a very real difference in geographic space. People in Neufreistadt do not appear on CN minimaps, and vice versa. This will restrict intersim communication to some extend, increasing insim connections. This increase of sim-specific connections will have cultural and political effects that must be accounted for in our political system or people will eventually feel alienated or shortchanged. (In fact, I think we already see some of this in Ranma's posts.)
Further, even with the walls separating urban from rural life in Neufreistadt, there was nonetheless a thematic kinship. Just as any ethnologist would see the cultural distinctions between Neufreistadters, that same ethnologist would also see the basic cultural and social unity of the community. More likely, ideas of class or lifestyle would apply more than ideas of radical cultural distinctiveness.
I will grant that the cultural distinctiveness between the CDS sims will probably not be truly radical. However, I also expect that that distictiveness will be greater than the class or lifestyle distinctions within a sim. Neufreistadt may have grown up like a Bavarian city -- with a historical core surrounded by the trappings of modern German society -- but such cities in RL (and in SL) are still Bavarian.
CN is more thematically controlled than Neufreistadt. There is not a shift in time as we pass out of the walls. The entire Sim is frozen in history. However, by freezing CN in Republican/Imperial Rome, we also liberate ourselves by providing real avenues for certain "historic" activities that would be out of place elsewhere (especially in a German town with a prominent Church).
As we continue to grow, assuming we do not reject sim theme differences as a failed experiment, the general population will necessarily become more and more diverse overall (as an issue entirely separate from the RL diversity of the people behind the avatars). This diversity needs an outlet -- and the safest and most ready-to-hand outlet is local control of the details of local life under the more general and loose guiding hand of a unified CDS Federal government which involves itself in Federal concerns and new sim creation, leaving the daily life of each existing sim to those who live it.
Beathan