Angela Merkel’s failure to land a decisive victory in the German elections has sent shockwaves around the European Union and left supporters of economic reform in despair.

The stalemate in Germany came as a heavy blow to Tony Blair, Britain’s prime minister, who hoped to use the UK presidency of the EU to promote economic reform and the reshaping of Europe’s social model.

Mr Blair was counting on Ms Merkel winning a solid mandate for reform in Germany to send a signal to other European countries on the need for deep supply-side changes.

The British had envisaged next month’s informal EU summit at Hampton Court near London as Ms Merkel’s first major European set-piece occasion.

Instead the turmoil in Germany means it is possible that Mr Blair will greet Gerhard Schröder at the Tudor palace on October 27 if Ms Merkel fails to form a government.

Relations between Mr Blair and Mr Schröder have passed the point of no return, after Britain’s blockade of a deal on the EU budget at last June’s summit and divisions over the war in Iraq.

British diplomats admit that “bridges have been burned” with Mr Schröder. “The picture of the two of them meeting at Hampton Court will be one to treasure,” said another EU diplomat.

Officials close to the British presidency say “Blair put all his hopes on Frau Merkel” as the key to a successful six months in the chair of the EU.

Mr Blair hoped that as a strong chancellor Ms Merkel would not only back economic reforms – including proposed legislation to open up the EU services market – but help to broker an agreement in December on the next seven-year EU budget by arguing for further farm subsidy reforms.

Charles Grant, director of the Centre for European Reform, said: “An awful lot of people thought she would win decisively and that would allow the EU to start again.

“It’s hard to see how a grand coalition would be particularly good at pushing through the structural reforms that Anglo-Saxons think are necessary.”

However, Mr Grant argues that if Ms Merkel did become chancellor, the acrimonious group dynamic of the EU – which has pitted Mr Schröder and Jacques Chirac, French president, against Mr Blair and José Manuel Barroso, the liberal European Commission president – could change.

“It would leave Chirac much more isolated at European summits and relying on a dwindling group of friends,” he said. Those would include Guy Verhofstadt of Belgium and José Luis Rodríguez Zapatero of Spain, although the latter has recently started to work more closely with London.

In France, Thierry Breton, the reform-minded finance minister, said: “What’s important is that Germany pursues its reforms. The path of reform that Germany is on should not be disturbed, no matter which way the scales tip.”

However, leftwing politicians in France said German voters had emphatically rejected radical free market reforms of the kind espoused by Nicolas Sarkozy, the interior minister and presidential hopeful.

Ms Merkel’s poor showing is also a serious blow to Mr Barroso who hoped she would provide some much-needed support for his economic reform agenda, including his plan to revive the EU services directive.

“I have a duty on behalf of the European institutions to urge German political leaders to a solution as soon as possible that is stable for Europe,” Mr Barroso told the European parliament on Tuesday.

However, the political confusion in Germany has been a source of some comfort to Turkey, which hopes to start EU membership talks on October 3.

Ms Merkel opposes Turkish membership but will be in no position to influence negotiations with Ankara in the next fortnight as she struggles to form a government. “It was an auspicious result for the EU process,” said Recep Tayyip Erdogan, Turkey’s prime minister.

However for many, the election result was another setback for the EU, still reeling from the rejection of its constitution by France and the Netherlands and bitter disputes over the budget and economic reform.

“European policy, which has been in disrepair since the referendum in France, risks becoming more paralysed than ever,” said the French newspaper Le Figaro.