* Merkel emphasizes flexibility of EU budget rules
* Comments likely to please Italian PM Renzi
* Britain set for harsh defeat over Juncker at summit
* EU leaders may meet again on July 16 to decide other top EU jobs
By Luke Baker
BRUSSELS, June 25 Britain's slender hopes of securing Italy's support in its bid to stop Jean-Claude Juncker becoming European Commission president crumbled on Wednesday when Germany offered Rome on a gentler interpretation of EU budget rules.
Chancellor Angela Merkel's acknowledgement that European Union deficit curbs should be applied flexibly to promote growth was a gesture to Italian Prime Minister Matteo Renzi, all but ensuring he backs Juncker's nomination at a summit on Friday.
"The German government agrees that the Stability and Growth Pact offers excellent conditions for (promoting growth and competitiveness), with clear guard rails and limits on the one hand and a lot of instruments allowing flexibility on the other," Merkel told Germany's lower house of parliament.
"We must use both just as they have been used in the past."
The EU summit starts on Thursday with a solemn commemoration in Ypres, Belgium, of the outbreak of World War One a century ago in which millions of Europeans died. That will be followed by a working dinner on the EU's long-term policy agenda before the contentious decision on the Commission presidency on Friday.
The tilt in economic policy and the likely appointment of Juncker highlight a new political balance in Europe that is set to shape the EU's institutions for the next five years, with the risk of Britain drifting away.
British Prime Minister David Cameron renewed his promise in parliament to fight to the end against Juncker's nomination and seems set to be defeated in an unprecedented summit vote.
The tentative convergence between Italy and Germany points the way towards a German-style "grand coalition" of the centre-left and centre-right at European level, with Renzi, the young reformer, in the frontline with Merkel.
Renzi, whose centre-left party won a resounding victory in European elections last month, boosting his profile on the EU stage, has made budget flexibility a central issue as he searches for ways to kickstart his flaccid economy.
Sandro Gozi, Italy's undersecretary for EU affairs, accepted there was no question of altering the 2005 stability pact, just a need to apply it more flexibly to favour investment spending and allow countries implementing growth-enhancing reforms extra time to meet deficit and debt targets.
"No one is asking to revise the pact but to use the rules to their maximum," he told la Repubblica newspaper.
In a warning shot to placate German fiscal hawks, Merkel's conservative parliamentary group said Renzi wanted to deviate from the path of stability but Berlin would not allow any "dirty tricks" that put Europe on a "comfortable but fatal debt track".
Italy takes over the EU's rotating presidency six months in July, determined to re-energise the union and change the way it works. In a speech to parliament on Tuesday, Renzi, 39, said he was fed up with the EU acting like a "nagging old aunt".
Asked who Renzi saw as his natural allies in overhauling the EU machinery, a senior Italian diplomat said France, Britain and Germany all had reason to share Renzi's view and had to one extent or another given their support.
MOMENT OF TRUTH
Going against the European grain, Cameron has waged a vocal campaign against Juncker, 59, casting him as an old-school federalist who does not have the skill or energy to breathe new life into the EU.
He has also objected to the principle of EU leaders' letting the European Parliament effectively determine the choice, since Juncker was the leading candidate of the centre-right group that topped the poll in the European elections.
British Europe Minister David Lidington said choosing the Commission president from among those leading candidates risked making the EU executive a "creature of the European Parliament".
But Juncker, who was prime minister of Luxembourg for 19 years and has been at the heart of EU decision-making since the early 1990s, including shaping the Stability and Growth Pact, has firm backing from Merkel and most other EU leaders.
One of Cameron's few allies, conservative Swedish Prime Minister Fredrik Reinfeldt, said on Wednesday he was ready to support Juncker if a majority of leaders backed him, leaving the British leader increasingly isolated.
Herman Van Rompuy, president of the European Council and chairman of EU summits, is determined to secure Juncker's nomination before the summit ends on Friday, even if it means a vote that leaves Britain isolated and defeated.
Normally EU leaders take decisions by consensus. But because Cameron is holding firm and demanding a vote, a showdown looks increasingly likely.
An EU ambassador said Cameron would probably lose it by 26 votes to 2, with only Hungarian Prime Minister Viktor Orban joining him in opposition.
It would be the second time Britain has been left on the margins on a critical EU issue in the past three years, having been one of only two countries to veto new budget rules for the euro zone at the end of 2011.
The confrontation has badly damaged Britain's reputation after 41 years as a member of the union, a senior minister in Cameron's coalition said on Wednesday, but it has gone down well so far with British voters.
A poll conducted by Populus for the Financial Times found 49 percent of people thought Cameron was taking a strong stand, with only 22 percent perceiving him as weak.
Yet while his tough stance may go down well at home in the short run, it could increase the likelihood of Britain eventually leaving the European Union, which Cameron has said he wants to prevent.
If he is re-elected next year, Cameron has promised voters an in/out referendum on membership by the end of 2017 after he tries to renegotiate Britain's relationsihp with the EU. Some polls show more Britons now leaning towards "Brexit".
EU officials and diplomats are working on ways to prevent Britain being left out in the cold. One official said if Cameron dropped his demand for a vote, Britain could be given the top economic job in the Commission, or a similarly powerful post.
But there is no sign Cameron will accept such an inducement. A British official close to him said this week the prime minister would not be "bought off" by EU leaders. "Some principles are worth fighting for," the official said.
If as expected Juncker is nominated by EU leaders, he will have to be approved by a majority in the European Parliament in a vote set for July 16.
Tentative plans are being made for EU leaders to meet again on the same day to discuss the other top jobs that have to be filled, including a successor for Van Rompuy, an EU foreign affairs chief, a economics czar and the rest of the 28-member Commission, the EU's executive.
That would bring Cameron back face-to-face with his fellow EU leaders barely two weeks after an uncomfortable showdown. (Additional reporting by Jan Strupczewski and Justyna Pawlak in Brussels and Stephen Brown and Michelle Martin in Berlin; Writing by Luke Baker; Editing by Paul Taylor)