I think I was first to mention the "circular problem" in this post. Pastaav, I think you're missing the point. It's not a problem that the dagger user attacks after the spear user. The problem is that the book gives initiative bonuses in "melee vs melee" - as opposed to a GENERAL initiative bonus. That screws up the order when there are non-melee users included as well (and possibly also with three melee-users, where two are attacking each other and the third is attacking one of the two).
How does one interpret this "melee vs melee" bonus? Pastaav, I think you interpreted it as a GENERAL initiative modifier - and as a PENALTY to the (shorter weapon/weaker fighter/not one-hand free/not pole-arm) person. That may very well WORK (not sure I agree, but that's beside the point), but it's definitely not what the rule book describes. The rule book gives BONUSES in "melee vs melee" situations, and does not say anything about how to solve the "circular problem".
Personally, I think this belongs in the errata. And I think that either:
a) The "melee vs melee" bonuses should be dropped entirely; or
b) The bonuses should be made GENERAL bonuses, some possibly positive (like one free hand), and some possibly negative (shorter weapon?)
Of course, some could be dropped and some could be made general, but ANY modifier to initiative HAS to be made a general modifier, not a modifier against one spesific opponent, or a specific type of opponent (having +3 to init vs orcs would cause the same problem, of course).
Another similar problem arises with crit results saying "you have initiative". Great! But what if I attack another target - do I still get init? Or if I DO attack the same target, we could get another "circular problem" when a third player intervenes. In our games, we have changed all "you gain initiative" to "you get +10 to initiative" (assuming this is because you're "on a roll" or something), and "you lose initiative" to "you get -10 to initiative".