Hi Jenny - I hope things are going well with you and Jess! I'm happy to say that the 2 Germ Sheps I have now are wonderful with kids, but my previous GSD was not. When I adopted her at 15 mos old, she'd just as soon eat the kid and ask questions later. One wrong move and she went ballistic. It was scary. We worked hard and long with a great trainer. He had us spend *literally* hours upon hours upon hours (for weeks and weeks and weeks - she was a really hard case), sitting in a park near where the kids play, and just letting her watch them. For a long time, she'd stay standing, she couldn't even sit. Gradually, she sat, and finally I knew we had made real progress when we could go to the park, I'd find a bench, sit down, and she'd lie down and relax. Of course, I'd never let anyone touch her or get near her - that way, no pressure. It then moved on to where I found a child in our neighborhood and started working with them, set something up, and would have them approach very slowly, with treats, always petting under the chin or on the chest or back - only good things happened when kids were around. She grew to absolutely love kids and would seek them out. Going to the park and getting pets from kids ended up being a real treat! (I barely believed it myself - miracles do happen!!)
Perhaps (not knowing what your weather is like) you could find a playground or park and do some relaxation work with Jess, getting her totally comfortable around lots of movement - kids running, playing, screaming, etc. When it's obvious she's just not caring if kids are darting anywhere (or if she's like that now), find someone you could work with - a friend, or even a friend of a friend (someone with a child, preferably an older child to start out with), a neighbor, etc, and go slowly, use treats, watch Jess' body language, have the child always softly pet the chest, back, under the neck - never the face or top of the head. Do watch kids, cuz that's just the first place they go for - they always pet dogs on the top of the head. Teach kids (any kids) that dogs just don't like that (cuz some don't - and with strange dogs, best not to go there). You also give Jess treats and tell her what a good girl she is, if she's standing there politely accepting the pets of the child. If at any time you see her tense up, then end up and remove her. As with the other desensitization work you were doing, she'll trust (and thank you) that you won't push her too far, and will be grateful you took the pressure off her. If she's enjoying herself, she'll appreciate her new-found friend and will want more (as my girl discovered).
As for your friends, and their tensing and getting nervous - there's nothing you can do about that. Are they afraid of dogs? It sounds like they may be. Explain that yes, it's good to always be vigilant around kids and dogs. It's just common sense. But to get very nervous can actually bring on unwanted behavior - the dog might react negatively to the tension. If they act like that every time they come over, I'd say put up a baby gate and keep Jess separated (for everyone's peace of mind). Jess won't get any bad vibes she'll associate with kids (every time a kid comes around, people freak out - kids must be bad). If they can be calm and work with their child and Jess - have them keep their little girl calm (she's old enough to learn to pet the doggie quietly, and you can give her a treat), you give the commands to Jess and she can treat, make it a two-some, the two of your very close together, working with Jess, maybe asking Jess to lie down - does she like belly rubs? Try sitting quietly doing belly or back rubs while Jess lays on the floor - maybe small increments, then give Jess a break - til everyone gets comfortable (over time). Don't rush your friends, or Jess - just let the relationship happen when it's ready. Let Jess get used to kids on her own time, and let your friends get used to the idea that their little girl will meet dogs in this world, and she needs to learn how to do it (for her own safety).
Just read your post again - about sniffing your friend's girl? Keep in mind, Jess' nose is very very powerful. Jess doesn't need to be right up on her to get a really good smell, she can accomplish that from a little ways away, or she can smell someplace the child has just walked, etc (or a sweater or something she just wore in) if you want to give her a really good sniff. I think that would make your friends way too nervous right now.
I hope some of this helped. I'm sure someone else will chime in, maybe TxCwg? Good luck!