The initial problem means you've got your mercurial-server installation into a confused state. After creating the "hg" user, the install scripts place a configuration file called ".mercurial-server" in its home directory. This file somehow got removed on your system - perhaps you created the "hg" user by hand? That's why deleting and reinstalling all fixed everything, because it ran the install scripts and created this file.
The second problem was simply that the "hg" user was unable to read the "localhost" file you created. 777 gives write permission to all - never do that! 644 for files and 755 for directories will suffice. It looks like you have your "umask" set to an unusually restrictive mask.