If you ever hear someone say "Blu-Ray isn't needed for this generation," rest assured they don't make games for a living. At Insomniac, we were filling up DVDs on the PS2, as were most of the developers in the industry. We compressed the level data, we compressed the mpeg movies, we compressed the audio, and it was still a struggle to get it to fit in 6 gigs. Now we've got 16 times as much system RAM, so the level data is 16 times bigger. And the average disc space of games only gets bigger over a console's lifespan. As games get bigger, more advanced and more complex, they necessarily take up more space. If developers were filling up DVDs last generation, there are clearly going to be some sacrifices made to fit current generation games in the same amount of space.
Granted, some really great Xbox 360 games have squeezed onto a DVD9. Gears of War is a beautiful game and shows off the highest resolution textures of anything yet released, partly because of the Unreal Engine's ability to stream textures. This means that you can have much higher resolution textures than you could normally fit in your 512 MB of RAM. It also means that you're going to chew up more disc space for each level. With streamed textures, streamed geometry and streamed audio, even with compression, you can quickly approach 1 GB of data per level. That inherently limits you to a maximum of about 7 levels, and that's without multiplayer levels or mpeg cutscenes.