The install thing sounds problematic. Have you tried just deleting all the files manually and having Steam validate the game cache?
As for the bug itself, it could be a Steam thing. I use it with the disk GOTY and have no difficulties. Did you have a vanilla Morrowind install? That's strongly recommended. I tried without a vanilla Morrowind install once and I kept running into invisible walls. -_-
You can certainly use it with separate mods; I use several. You just have to be careful that they don't conflict, and other mods you intend to use should be installed carefully after MGSO.
Also, make sure you're using MGE XE in the advanced configuration options for MGSO. As far as I know, that's the best and newest version, and it's the version I use. Alternatively, you could try reinstalling Morrowind, only installing MGE XE, and check if that works. If it does, then the problem is probably not an unavoidable one. If it doesn't work, I would have to assume that MGE XE takes issue with either your specific hardware configuration, or with Steam.
If MGE XE doesn't work in any capacity, I would recommend trying a different version of MGE. You'll miss out on some of the more advanced effects, but it'd still be a vast graphical improvement over vanilla. If no version of MGE works, or no version with sufficient graphical improvements for your taste, I would recommend getting a physical version of Morrowind, if possible.
@Themisive
Admirable from a fan's objective perspective of the series, but not very helpful to the OP in this case.
Edited by Rennn, 02 August 2012 - 03:51 PM.