that's not how photoshop has ever worked for me, and i don't recall ever playing with the settings like that. i use crtl+e @ home and it 'merges down' as the menu says, and i use ctrl+e @ school and i know i haven't touched those preferences because i keep forgetting to boost up the history number and i use crtl+e quite often.
both layers have to be rasterized of course. maybe if you try to merge down a text/shape element it flattens everything, but i never try doing that, so i can't say. but i know for sure 2 raster layers should merge down.
ALSO i'm using both
ps 7 and CS so it shouldn't be a version thing.