A year and a half ago I wrote a tutorial about proxy editing with Vegas. There is now an automated visual solution, written by a French developer (update: ask *him* for support btw, for some reason people think that I wrote that script), that is much easier to work with. However, it requires Vegas Pro 8+. The Movie Studio versions of Vegas won’t work with it, as they don’t have scripting support, so if you are using Movie Studio, you will still have to use my own tutorial as a solution.
So, download Proxy Stream from here, unzip it, and copy the files on your Vegas’ Script Menu folder (on my PC it’s here: C:\Program Files\Sony\Vegas Pro 8.0\Script Menu\ ). Then start Vegas Pro, load the script from the Tools->Scripting->ProxyStream and tell it what kind of filetype you want to create proxy files for, and which files in which folder on your hard drive.
Then, select the format to convert to. I suggest you go with MainConcept mpeg2, but click “custom” to customize it, don’t use any of the templates offered there. So, click “custom”, and in the new dialog select “good” quality (no need for “best” that slows down encoding at this point), 640×360 resolution with square pixels, the right frame rate (NTSC or PAL or 24p), progressive field order, and no more than 640,000 bps constant video bitrate. Use 64 kbps for audio encoding. Then click “ok” to that dialog, and then “Convert” on the Proxy Stream dialog. It will take a bit of time to create the mpeg2 files, be patient.
When the conversion is done, set the project properties to the mpeg2 proxy files’ properties. Select “best” quality and “interpolation” for deinterlacing on that project properties dialog. Do your editing, save often. When all is done, load again the Proxy Stream script, select the “switch” tab, select “source files”, and then “switch”. Now all the mpg clips in the timeline have been automatically switched to the source files! Then, change the project properties again to reflect the source files’ properties (just use the “match media” icon in that dialog to set the right project properties). Then, export your high quality video using these source files.
If all that don’t work with a newer Vegas Pro version, use my manual proxy method, linked above.