Step 1: Let the retailers sell the console at a decent profit margin.
Step 2: Invent a distribution system that is similar to what Nintendo does with its Wii points cards. 90% of the consumers won't own credit cards and will have to buy said "points" (or whatever) in the store. Or: Make games download only but still release them in stores as packages with a code and a manual in them.
And suddenly no retailer will complain.
When saying "digital distribution won't work" you can't just assume that Sony for instance (with the rumoured PSP) won't put any effort into it. Digital distribution can definitely work, you just have to involve the retailers a bit.
Oh and I bet you most people don't actually think having no physical media is bad: They just think buying "nothing" is rather strange and I agree with them. But if you got a plain normal box with your game that contained a manual and a code for instance nobody would complain. It would actually be great for portable consoles: You could have all your games with you, without wasting any space for UMD's or cards. The definition of "portable" 
Edit: And for those people without internet you could use download stations just like what Nintendo did with the DS. You just need to go to an internet cafee, a McDonalds or whatever and you can download your game.
