There are so many misconceptions in the post by 8thnerve that it's hard to even know where to start...
I'd like to address this oft-repeated statement that digital "has only two levels, on and off." This is true only on the most fundamental and/or naive level - it's a bit like saying that the financial systems of the world are based on a system that has only ten numbers. Digital information is stored and manipulated in binary numbers
only because it happens to be the best way to make digital circuitry (i.e. the underlying hardware). As JoshK pointed out, ternary logic circuits exist(ed); I'm sure it would be quite possible to make ten-level logic circuits, it just wouldn't be very practical.
So, a binary number is just a number. It can be manipulated like any other number, it just has a different base. If you need bigger numbers, use more bits (note: "bit" is a contraction of "binary digit"); if you need smaller differences between numbers, use more bits again. This is just like saying that if your bank account has a million dollars in it, you need more digits to represent it than if it has only a thousand dollars in it. And, if you need to write down the number of cents as well as the number of dollars, again you need more digits!
Digital is just numbers -- the fact that it's binary or "has only ones and zeroes" is COMPLETELY IRRELEVANT.
Now, the notion that digital information can be manipulated losslessly is FALSE. Presumably you have all done a tax return, and on your calculator produced a number like, say, $1528.476248243. What do you write on line 463 of your tax return? You write $1528.47! (Or $1528.48, depending on how much of a pedant you are...) You have just LOST INFORMATION. The exact same thing occurs when processing audio represented digitally.
For example, suppose you have two 16-bit numbers (as you do with CDs). If you multiply them together, you get a 32-bit number. Multiply two 32-bit numbers together and you get a 64-bit number. And so on and so on. This is not a made-up example -- multiplication is one of the two fundamental operations in ALL digital filtering -- ie eq. (The other is addition.) But sooner or later you are going to have get rid of some of those extra bits you have accumulated! Voila, LOSS OF INFORMATION. This is EXACTLY like removing those extra digits when you have to write the number into the box on your tax return.
Now, the IRS might not care about a few cents either way, but in audio processing the loss of these bits causes NOISE. In some types of digital processing and if done incorrectly, it can even cause instability.
JoshK raises some much more interesting points, to which I'd like to respond a bit later

JohnR