A new German government and the imminent single currency are putting Blair and Brown on the defensive
Not long after last year's general election a meeting in Downing Street debated a bold way of bringing Britain back into the centre of Europe. Tony Blair would sign up to the single European currency in exchange for a two-year delay in its starting date.

The Prime Minister seemed enthusiastic - until one aide pointed out that the then German Chancellor, Helmut Kohl, would never postpone the launch of his prized common currency, let alone at the behest of sceptical Britain.

Last week the Government's European strategy was back on the drawing board, derailed this time by more concrete disagreements with the government in Bonn, now of a different political hue. The spark for the conflagration came from the new German finance minister, Oskar Lafontaine, whose comments on tax harmonisation set off a frenzied set of newspaper headlines. The Eurosceptic tabloids were inflamed. With "Red Oskar" confirmed as the Sun's new bogeyman, the conflagration spread.

France's finance minister, Dominique Strauss-Kahn, stirred the pot, backing Mr Lafontaine's controversial ideas that member states should lose the veto over tax policy. Then Gerhard Schroder, the German Chancellor, endorsed his finance minister's views in a newspaper interview. At an Anglo-French summit in St Malo on Friday even a significant breakthrough over defence co-operation was marred by familiar discord over the British budget rebate, won by Margaret Thatcher in 1984. Behind the scenes there was tension between No 10 and No 11 over Gordon Brown's handling of the tax row. With the 15 European leaders heading for a summit in Vienna on Friday, Mr Blair's European policy has rarely looked so shaky or so alarmingly reminiscent of that of his predecessor.

New Labour's first moment of truth over Europe arrived last autumn when, in the face of newspaper speculation about the single currency, the Government was forced to stake out a position on the most controversial issue it faces. This time the early, bold talk of entry into the single currency was ruled out in favour of something more cautious. A delay in putting the issue to the British people until after the election would allow time to judge the project's success, during which, the Government hoped, public opinion would be won round.

Although reluctant to give a lead, the Government gently encouraged business and industry to argue the merits of a common currency, and stress the dangers of staying out. This was the course of least resistance. It did not involve taking risks with allies in the Murdoch empire and tabloid press. And it seemed to be working - until September's German elections.

At first the triumph of the modernising Mr Schroder was welcomed in London as an opportunity to break into the Franco-German alliance. But his unexpectedly large majority gave the new administration a centre of gravity well to the left of New Labour. Where some had expected a coalition with the Christian Democrats, the Greens were invited instead. Not only did this bring them into senior positions, in the form of the foreign minister, Joschka Fischer, but it meant no political counterbalance to Mr Lafontaine, more of a Keynesian than an economic liberal.

THE BRITISH government's instinct was to sign up to an agenda from the new European left, which had been bolstered by the election of Massimo D'Alema in Italy. Aware of its loss of influence through non-membership of the single currency, New Labour fought hard to stay on the inside track. At a summit beside a tranquil Carinthian lake in Portschach, Mr Blair fell into line with the new consensus. Aides to Mr Brown were busy helping draft a new manifesto for the socialist group of finance ministers, called "The New European Way".

Behind the scenes, however, things were not so smooth. A row smouldered over the British budget rebate, worth pounds 2.6bn a year. Since its negotiation, four other nations have become big net contributors, and the continuance of the full British rebate after enlargement of the EU is seen by most as untenable. Several member states were getting impatient with New Labour's famed spin-doctors. At a discussion of the budget rebate in a meeting in Luxembourg, the Dutch finance minister, Gerrit Zalm, prefaced his contribution thus: "Before my colleague Brown goes out to tell the British press that nobody has discussed the rebate, I am taking the opportunity to tell him that it is about time that this system of British compensation was finished."

When the row came, it was a sizeable one, with a protagonist able and willing to give as good as he got. The issue was tax harmonisation, which crept on to the agenda at a dinner for socialist finance ministers two weeks ago. Mr Brown and Mr Lafontaine, seated next to each other, publicly disagreed. A subsequent threat from Mr Brown to veto any moves in that direction appeared to be one motive behind Franco-German retaliation last week.

There was little mistaking that this was part of a deliberate strategy designed to put Britain in its place. Even before the French finance minister had intervened, one aide circulated in the coffee bar of the Justus Lipsius building in Brussels, making it clear to journalists that, on tax harmonisation, "every page" had to be opened.

The ensuing fuss bodes ill for the Government and particularly for Mr Brown, whose portfolio includes most of the difficult decisions. The row over tax harmonisation has raised the tempo over proposals that were once relatively un-newsworthy. They include moves to combat "harmful" tax competition under a code of conduct group chaired by a Treasury minister, Dawn Primarolo. Last week Mr Brown was forced on to the defensive by reports that tax breaks for the film industry were likely to fall foul of the agreement.

More problematic is the withholding tax on savings, designed to combat the problem caused by the ability of investors to avoid tax on interest payments by investing in foreign countries. Until last week British opposition to the measure, which the UK can veto, was based on the fact that it would hit London's lucrative Eurobond market, threatening as many as 11,000 jobs. But as the heat intensified Britain hardened its opposition, attacking the "real" problem, namely banking secrecy in Germany and Luxembourg. That means that a compromise, which might have been acceptable two weeks ago, is now a political impossibility.

IT REMAINS unclear how hard Germany intends to push its broader agenda for tax harmonisation. But because it holds the presidency of the EU from January, its finance minister is in a position at least to embarrass the Government by promoting the issue either through the finance ministers, or through the socialist group. Then there is the British rebate, which will inevitably feature in coming discussions on financing the EU. Having ruled out any concession here, the Government is again boxed in. Meanwhile the Chancellor faces exclusion from the potentially powerful Euro-11 committee of finance ministers from the countries taking part in the single currency. While this could point to a repeat of history, with Britain backing away from further European integration, such a move is far from inevitable.

Mr Blair's room for manoeuvre remains infinitely greater than that of his Conservative predecessor. There has been a solid improvement in relations in many areas - as exemplified by Friday's Anglo-French defence deal - and the imminent lifting of the ban on British beef exports. More important, Mr Blair has a huge parliamentary majority and, unlike John Major, almost no backbench dissent over Europe; meanwhile the Opposition is in disarray.

The Government's difficulty is one of media management, rooted in New Labour's near-obsession with the tabloids and the Murdoch empire. Privately, the Prime Minister defends this on the grounds that no newspapers can be relied on to support his cause, in the way that the Tory tabloids backed Mrs Thatcher in the 1980s. But there is a growing consensus within the party and the Foreign Office that this success with the press is becoming a liability. One source even conceded last week: "When the Sun came out for Labour before the last election, my heart sank. I thought 'here we go again'."

The inquest following last week's debacle could mark the beginning of a shift. The Prime Minister's office is said to have been less than impressed by Mr Brown's veto threat, blamed by some for the furore. As one government source put it: "Not only did it give the idea that we are all alone, when we are not, it created the impression that we felt threatened. It was an example of playing to the domestic agenda without thinking about the long-term interests."

Ultimately the Government will have to choose between pursuing a pro- European agenda, taking Britain closer to the single currency, and courting the Eurosceptic tabloids. Last week showed that that crunch may be closer than Mr Blair thinks.