What is the downside to Windows XP style DPI scaling in Windows 7

This answers your question rather well. In short, XP mode scales up the font and UI object sizes as if you'd gone and adjusted your theme's size settings, which can cause some graphical anomalies in some apps that're hardcoded to use default font and icon sizes.

"Vista" mode draws applications as standard 96 DPI to an off-screen buffer, and scales them up using your graphics card's texture resizing routines. If you've ever loaded an image with a lot of fine pixel detail into an image editor and resized it up, you'll probably find the induced fuzziness similar.

IMHO, they're both terrible hacks to get around the fact that truly DPI-independent applications are nearly nonexistent. Shame, really.

You should always check the 'XP style font scaling' box. Otherwise, many applications (Google Chrome, for one) look blurry.