problem authenticating with encrypted passwords in pg_shadow

I just upgraded to postgresql 7.2 and I'm having trouble connecting to the
postmaster with psql.

Here is what I've done:

I added this line to the top of the pg_hba.conf file.

# TYPE DATABASE IP_ADDRESS MASK AUTH_TYPE AUTH_ARGUMENT
local all
md5

Now I connect to the postmaster with the postgres account using psql
(postgres' password is stored as plain text in pg_shadow so I can connect
without any problems) and I run this command:

CREATE USER test WITH ENCRYPTED PASSWORD 'blah';

When I try to connect with the user test form the same host the postmaster
is running on, (psql -U test -d template1) I get the response:

psql: FATAL 1: Password authentication failed for user "test"

When I change the password for the user test back to plain text I can
connect fine.

Anyone know what's going on?

Thanks,

Joey