128MB or 256MB flash storage does replace a HDD, to a limit at least.
Ok, you can't put much custom soundtracks there, but for the average user I can see a 256 MB memory card wouild last about one year when used for downloadable content and game saves.
When the card gets full, he buys another, possibly a bigger one.. or even a harddrive.
I don't see the HD really as a big deal, even as it's missing from every retail xbox360.
I believe the games like "Elder Scrolls Oblivion" can easily be playable with a biggish memory card, if the HD's main advantage over memorycard would be data caching (would that only make the programming harder, I mean all those multithreads and caching on top of that... I really don't know, I'm no programmer.. just a thought) and custom soundtracks... I'm actually glad they don't force it to everybody who really has little need for it.
It would seem you'll anyway be able to use the PC as a mass storage and stream from there, not as good as local storage of course but for many a better option to keep it centralized.
To me it looks like the motive for many of those who have been overly vocal pro the standard included xbox360 HD, has been mainly that they've seen the HD as one of the major strong blows against PS3 and a powerful weapon against Sony's success, even though they really wouldn't have that much need for the HD personally.
Now that it seems that "advantage" is gone, they are disappointed and afraid they've lost an important weapon against PS3 in the console wars