This is something I pondered on way back when the XBox 2 was first announced, and rumoured to not have a hard drive at all. Realising that the ‘memory cards’ from the XBox are basically USB flash memory, my thought was that a 1GB flash memory stick would be plenty enough for hundreds of savegames, patches and extra content.
So it is not at all beyond imagining a several-GB flash-based hard drive for the XBox 2. Hell, they could even make it some sort of nifty portable media device. You could carry around all your savegames, screenshots, and media content. Listen to your music on headphones, or drop it into your XBox2 and play your music through your home theatre setup.
Convergence is the buzzword. Imagine synching this portable dongle with your PC and XBox2, store your calendar and everything. Possibilities!