Define worse. When I got an iPhone, my iPod went into complete disuse, and I ended up giving it to a friend. The iPhone/iPod touch interface is, to me, far and away better than the original iPod interface. This was then bolstered with the new earbuds that added volume control to the pre-existing track control on the mic/clicker.
It certainly has less drive space than older iPods, but I have yet to fill up my iPhone. I understand using the old iPod as a portable hard drive, but storing your entire music collection on it never made sense to me - which is why I gladly traded the smaller drive space for the better interface.
Obviously it depends on personal taste and use, but I think the Touch has a couple of serious deficiencies compared with the others. First, I believe that battery life isn't as good, although I could be wrong on that one. Second, it's impossible to play, pause, or switch tracks without actually looking at the thing unless you're using a compatible headset. Plus the storage space you mention.
I think the Touch and iPhone are more than adequate for the task, but they're not quite as good as the pure iPods, and that functionality is completely eclipsed by their other capabilities. I haven't used an iPod since getting an iPhone either, but that's just because it suffices, not because it's equally good.
It certainly has less drive space than older iPods, but I have yet to fill up my iPhone. I understand using the old iPod as a portable hard drive, but storing your entire music collection on it never made sense to me - which is why I gladly traded the smaller drive space for the better interface.