I think they'll keep the medium(DVDs) the same, possibly upgrading to Blu-Ray, but more than anything if they boosted the Xbox to PS3 levels if not beyond that, they'd have a good console on their hands.
I honestly can't imagine how developers are going to push the 360 past the graphical greats that are Halo Reach, Red Dead Redemption, and Gears of War 3 (I feel like I'm forgetting another game).
The problem is though, every time the console generation leaps forward, the prices of games leaps as well. PS2 games used to cost $50 brand new. Xbox 360 games and PS3 games cost $60 new. This is pretty invariable, and the price has never gone down. This creates the issue of, with all the money I'm spending on these games, I could save $30 of it (most of the time), buy the PC version, and save for better PC hardware instead of buying an Xbox/PS3 every few years that can't handle the same games.
Microsoft and Sony could fix this with a downloading service similar to Steam for consoles. Naysayers will bring up the PSP Go, but I think the main problems with the Go are broken promises.
As for the "720" being too soon, I disagree. They're just now beginning development, which means it'll be years before they do anything with it. The Xbox 360 began development in 2003, and it wasn't until late 2005 before anything came of it. Unless Sony makes a move too soon, Microsoft will spend more time creating and designing the device.