I have this problem on Desire Z too. After 1.4.29 I've been using Osimood's builds of MIUI. Tethering works just fine with it.
It could be because Osimood uses different kernel than miuiandroid.com version but I am not sure.
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The songs need to be in SD card/media/audio-folder. And you can't use subfolders. All songs need to be in root of audio-folder for Music app to find them.
That's pretty stupid that you can't put different albums in separate directories.