1/ Why adjust difficulty so infrequently?
On point 1: The 2 week cycle exposes the network to a number of attacks. [snip]
Why not a shorter cycle? In theory enough power could put the network in a stagnant mode for a long time until the next difficulty change.
The longer cycle prevents a number of attacks.
What you've described is rather costly and fairly modest DOS attack at best, its damage is limited by the difficulty change clamping, it's not profitable for the attacker beyond "disrupt bitcoin", and it exists outside of the security model of bitcoin in any case.
The expenses is a key factor: If you have the tens of millions of dollars of specialized hardware to outpace the whole bitcoin network by a significant fraction, why wouldn't you mine profitably using that power and if you are mining profitably then breaking bitcoin is not in your interest. If you're the sort that doesn't care about bitcoin profits (perhaps some government gone crazy) then there are far less costly attacks against bitcoin available to you (DDOS, writing laws, negative PR campaigns, hiring ninjas to kill developers). These attacks are likely to be far more effect too since the difficulty changes are clamped to 4x per cycle.
The most easily understood attacks that the long cycle prevents are ones related to manipulation of difficulty by miners via lying about the time.
Attack 1.
Because of the various physical realities of the world, we can only expect participating nodes to have approximately the same time. Because the chain splits when nodes disagree if a block is invalid, perhaps irreparably so depending on the nature of the disagreement, it's critical that any block validation be globally consistent. So we need to allow considerable slop on any blockchain time validation. The shorter the difficulty cycle is compared to the allowed time slop, the more lying miners can fake the difficulty, and thus artificially speed up the rate of inflation. Right now, they can only shift it by two hours out of ~two weeks. Which isn't that much.
Attack 2.
An attacker with some hash power, but not a ton has gained complete control of your network connectivity into the bitcoin network (perhaps they've compromised your ISP, or they're performing a sybil attack against the whole network. In any case, they're able to partition you.
In the worst case, you've been offline for a while and need a bunch of the block chain. In preparation the attacker has been mining a fork of the blockchain starting, perhaps, from the highest hard-coded checkpoint in the popular client software (or otherwise, if they know what you last heard). They're off on their own doing this. They mine out the rest of that DIFFCYCLE setting the timestamps to cause the greatest reduction in difficulty they can. They continue to mine, setting the time to result in a 4x reduction in difficulty each cycle. Every cycle of blocks they mine their work gets four times easier.
Eventually they get down to a difficulty low enough that they can easily produce one block per five minutes, and guide their timestamps back in line with reality.
Now you reconnect, they feed you their fabricated chain, proxying over transactions from the real network. Other than discrepancies in the block number, which joe-user won't notice, you can't tell that you're on a fantasy chain. Because they control your network you won't hear about the real chain. On the fantasy chain they can respend transactions that were spent elsewhere on the real chain, they can also cheaply reverse and respend transactions given to you at will on the fantasy chain, since they can easily mine forks on it.
With the long diffcycle this attack is prevented by two mechanisms: The long cycles mean that you must perform a enormous amount of work in absolute terms in order to drive down the difficulty at all. Unless you have enough hash power to challenge the whole network this will take you a very long time. Before a very long time has passed, users will have either heard of the more of the real longer chain so your target is constantly movin, or they will have noticed that bitcoin has gone weeks without working, and updates to the bitcoin client will have moved forward the furthest point in the past at which you can split the chain.
