That would work, and it has a neat recycle or frugality factor to it-waste nothing! But I think I have to agree with AJ, it probably works out to cost the same as an equivalent amount of Celluclay.
As for paper mache, I guess this is a variety of it, isn't it? There's not really any binding agent added, except the natural fibers in the celluose. But it would fall under the general category of it.
I've used the same process, for larger projects (like building a fake stone firepit for a stage play) using newspaper and water, but also flour, as the binder. I used a 5-gallon bucket, stirred in 5 lbs of flour, and the mix was like thick milk. Then I tore strips of newspaper, dipped them in the liquid, and applied them over forms of crumpled balls of newspaper. Worked the same-dries hard, takes paint.
I think you could also use plaster to make the slurry, keeping it very thin, but it'll impregnate the paper with it, and harden up, too.
Regards,
Brad