Think about it this way: If someone reads me a classical poem or text aloud, I have no idea what the hell it's saying.
With newspapers, you need to be reading to unambiguously figure out what is being said. In news reports on TV, the context is unraveled fairly quickly, but it's simply not as clear as having the text there. In fact Chinese news almost always has subtitles, not just for the sake of people who don't know Mandarin, but to clear up any un-clarity.
I do not think in anything but vernacular Mandarin and English, because I did not grow up reading much Chinese and was not schooled in it until recently. However, once I started learning higher vocabulary, I found that I could only remember it if I ingrained not just the sound but the characters into my head. Even just the general shape is fine.
I'm used to reading Latin letters, and I also learned Pinyin before Hanzi. Yet I still can't understand Chinese written in Pinyin much faster than if it's in Hanzi (more on this below). When I read Hanzi, my mind has a habit in some case of conjuring the pinyin instead of going directly to the sound, and this sometimes causes confusion. I tend to see a certain character wrong, think it's a different one, and try with bad results to make the sentence work according to the wrong meaning. If I didn't have the concept of pinyin in my head, I would have gone, if a little more slowly, directly to the correct pronunciation and along with it the correct meaning.
I have often talked with my mother, who is Chinese, about this issue. She learned Japanese and became fluent in it. I asked her if she had difficulties adapting to the Japanese readings of the Hanzi, and she said it wasn't really problem even the cases that the native pronunciation (totally different from the Chinese, in other words) was the correct one. The important factor is the picture and the meaning, which then instantly transform into sound, rather than the picture already being sound.
There was a test done by the Japanese that looked at the speed with which people could read signs on the street. Americans, reading English, were calculated to have understood the meaning in 0.8 seconds. Japanese reading hiragana understood it in 0.6 seconds. Japanese reading Hanzi understood it in 0.06 seconds. I don't have a source, so feel free to dismiss it, but given all my experiences with Chinese people I think it's valid.
The thing is that these languages are still phonetically-based. There is a high degree of phonetic production occurring in their vocabularies. I know English and German, and a small amount of Russian. Every one of these seems different to me and it takes some time to get into the correct mentality as far as the spoken language is concerned, but reading and working out the written word is pretty much the same for me across the board. Even Cyrillic is fairly easy to get used to. But Chinese simply doesn't mesh with an alphabetized script.
I think it really is the homophones. There are those tests they do where you take an English paragraph and misspell every word as much as possible, but they found that if the first and last letters stay unchanged, people fluent in English can understand it, albeit at a slower pace, like reading bad handwriting. This is because the words in English are generally different enough that they can form their own unique shapes in our minds, and when we read them, we see them as wholes, in a similar logic to how the Chinese see Hanzi. Chinese is not like this. The phoneticized lexicon contains far too many duplicates and similarities to create "natural shapes" that are unique enough to be recognized and understood with efficient speed.
Again, using myself as an example: I should be able to read Pinyin Chinese more or less fluently, because spoken Mandarin is at least a semi-native language to me, and because I am used to the Roman alphabet and I learned Pinyin before Hanzi. But I can't read it very fast at all. I can't read it anywhere near as fast as I read German, which I didn't study until a few years ago.
I think that illiteracy would not have severely impacted the ability of the Chinese proles to perceive things in a way similar to the literati, but that they would've found it much more difficult to to express themselves or complicated subjects, instead opting to use local dialectic slang for whatever might be needed. They might pick up some select literary sayings that would be otherwise incomprehensible to them, be it through provincial theater entertainment or a limited amount of education imparted from village elders or something, but they would be stuck at that limited level until they got the chance to learn Hanzi.
EDIT: I kind of want you to write the next update, so feel free not to waste the energy to respond to this.
