Tim Grey answered this question in his "Ask Tim Grey" newsletter today. He told me it was okay to post his answer here in its entirety. From:AskTimGrey.comToday's Question
Could you explain on a more technical level exactly what a Smart Object is and how it differs from a "dumb" object? This question is raised because of your remark about "de-smarting" by using Layer > Rasterize > Smart Object. So I guess it's not rasterized. But what does that mean?Tim's Answer:
A Smart Object provides a way to reference a source image to provide a non-destructive workflow approach for various tasks within Photoshop. In most typical workflows you would have the Smart Object embedded within your master Photoshop PSD file, for example, but Photoshop also now supports linked Smart Objects, where the source image for that object is not embedded within the master image.
This differs from simple pixel values in that it is possible to return to the Smart Object and apply non-destructive changes to your original adjustments. In other words, when you're using a Smart Object you're getting benefits that are similar to the workflow benefits of using adjustment layers rather than applying adjustments directly to pixel values in your images.
However, it is important to understand the workflow ramifications of using Smart Objects, which includes both benefits and potential pitfalls. Let's address the benefits first.
Because a Smart Object is essentially a "container" for image data, Photoshop is able to perform tasks in a non-destructive way that simply references the source data in that Smart Object. Let's consider a few examples.
If the Smart Object you're using is a RAW capture, the original capture data for that RAW capture will be embedded within the document you're working with in Photoshop, but adjustments via Adobe Camera Raw do not actually affect the original RAW capture data. As a result, if you open a RAW capture as a Smart Object, you can double-click on that Smart Object at any time to return to Adobe Camera Raw and refine the adjustments you originally applied.
If you are using a Smart Object to apply Smart Filters, you'll see the same effect you would otherwise achieve by applying one or more filters, but you can return to the filter settings later and refine those settings. In other words, you are effectively applying a filter effect in a non-destructive way, as though that effect were being applied using an adjustment layer.
You can also use Smart Objects for more complex scenarios, such as when creating a composite image. By embedded another image into a document as a Smart Object, you can, for example, resize that image as many times as you want within the composite without having a cumulative negative impact on image quality, because each time the Smart Object is referencing the original image data, not modified data.
Of course, as I've mentioned in the past when addressing Smart Objects, they aren't without their pitfalls. Most significantly, using Smart Objects can create problems in the context of a layer-based workflow. For example, let's assume you open a RAW capture as a Smart Object, then perform some image cleanup work on a separate layer using the Spot Healing Brush tool. Later you decide you want to change the appearance of the image, so you double-click the Smart Object to bring up Adobe Camera Raw, and apply changes to the photo. However, you are only affecting the Smart Object, not the layer with your image cleanup work, so the pixels on your image cleanup layer no longer match the underlying photo. It is this sort of issue that causes me to not use Smart Objects for most tasks, despite the potentially significant benefits offered by Smart Objects.
As for rasterizing, that refers to the process of converting an image to actual pixel values. So, for example, in the case of a Smart Object, rasterizing means converting the embedded image data and all of the saved adjustments related to that data, and process all of the information into actual pixel values. You end up with a smaller file (in most cases) but without the benefits of the Smart Object.