Well, one of the things we were hypothesizing online today was that all of the screens in the Architect scene were showing different Matrices running in parallel. So the recursion is only two levels deep; reality runs lots of artifical Zions, and each of those has an associated Matrix, and the Architect is lying (perhaps only by implication, though; he never actually says that there have been five previous Neos, only that there was a "systemic anamoly" and that Neo had "predecessors"). This explains how Smith can exert control over bodies in Zion and how Neo can affect the machines, but it is admittedly unsatisfying as an overall explanation.