Google (GOOG) is not a company known for making big mistakes, but not too long ago, it stumbled into the worst strategic blunder in its history. It’s not the acquisition of YouTube, which cost the company $1.6 billion, plus whatever it will take to settle Viacom’s (VIA.B) $1 billion copyright-infringement lawsuit. It’s not Google Buzz, which violated the privacy of untold thousands of Gmail users and prompted a class-action lawsuit. It’s not Google Book Search, which has led some of the nation’s most important intellectuals to wonder whether the company poses an existential threat to libraries around the world.

In fact, Google’s big bonehead play was seen by almost everyone as a great triumph, the latest in a long list of milestones along the way to world domination. Yet it was anything but that.

It was a mistake that helped save Microsoft (MSFT), its most dangerous rival, tens of billions of dollars that it can use in its war for supremacy on the Web. It’s a mistake that also infuriated not just Microsoft, but some of the most important institutional investors in the country. And it alerted the American and European governments to Google’s growing omnipotence, leading to numerous expensive and possibly brutal antitrust investigations. Google may spend years recovering from this one terrible error.
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In February 2008, Microsoft made an unsolicited bid to buy Yahoo (YHOO) and become the second-largest search engine in America after Google. The scale of the deal was remarkable; a combined Microsoft and Yahoo would account for almost 30 percent of the search advertising market, but the software company would have to plunk down a staggering $44.6 billion in cash and stock. What was perhaps even more remarkable, however, was Google’s reaction.

Up until then, Google’s executives had been content to quietly get bigger and bigger, always murmuring polite compliments about the competition and letting them wither on the vine. But this time, Google lashed out.

In addition to deploying lobbyists in Washington, Google’s most senior officials publicly denounced the deal and called on government officials to step in. “Could Microsoft now attempt to exert the same sort of inappropriate and illegal influence over the Internet that it did with the PC?” wrote David Drummond, Google’s head lawyer. “The two companies operate the two most heavily trafficked portals on the Internet. Could a combination of the two take advantage of a PC software monopoly to unfairly limit the ability of consumers to freely access competitors' e-mail, IM, and Web-based services? Policymakers around the world need to ask these questions.”

CEO Eric Schmidt was even more blunt, telling Portfolio, “The concentration of Microsoft's resources and its history, combined with the very large share that it would have in certain applications … could be used essentially to break the Internet.”

Google can’t take credit for killing the Microhoo merger; that, um, “honor” belongs Yahoo’s founder Jerry Yang, who couldn’t let go of his baby and cost investors a fortune in the end. But Google certainly made life difficult for Microsoft, raising the specter of Justice Department officials combing over the deal and picking over Microsoft just as they had done nine years earlier. The combination of Google’s hand-wringing and Yang’s ego ultimately proved too much for Microsoft, which walked away from one of the biggest deals Silicon Valley had ever seen.

And that, it turns out, was the best thing that had happened to Microsoft since MS-DOS. Consider what Microsoft would have had to do in order to digest Yahoo. It would have had to shell out at least $44.6 billion in cash and stock just to get the whole process started. Getting the deal past federal regulators, primed to be suspicious after Google and others beat the antitrust war drum, would have been an enormous headache. Although Microsoft has a lot of experience buying and absorbing other companies, integrating a separate operation of 13,000 employees would take years and result in a lot of expensive buyouts and layoffs. And there’s no guarantee that integrating the two companies would even work. (See AOL/Time Warner, the disaster that was.)

What did Microsoft get instead? It cut a different deal with Yahoo, in which Microsoft’s search engine Bing would power Yahoo searches, but Yahoo would collect 80 percent of the search ad revenue it sold for the next 10 years. Bing, born just last year, would suddenly account for 28.3 percent of the search market. Bing could use Yahoo’s brand to advance its own. Microsoft wouldn’t have to deal with redundant content or portals. Yahoo’s brand and search market-share were the only things Microsoft wanted in the first place, and under this deal, that’s what it would get. Two weeks ago, the feds approved the new Yahoo-Microsoft arrangement. If you don’t count Yahoo’s cut of future ad revenue, Microsoft just got everything it wanted from Yahoo for free.

“I think they got a much better deal the second time around,” says Clayton Moran, a tech analyst for the Benchmark Company. “They don’t take on the integration, they have much less financial risk, and they get the prize asset they wanted. I definitely think Microsoft ended up better off.”

But Microsoft didn’t feel this way two years ago. Especially when, just weeks after the deal died, Google announced its own, multibillion-dollar search deal with Yahoo. To the boys up in Redmond, this was sheer gall. Google, the new power man in the yard, had just managed to intervene in Microsoft’s affairs and start a new deal to enhance its already dominant market share, while coming off smelling like a rose and smearing Microsoft as Borg in the public’s eye yet again.

As Nicholas Thompson and Freg Vogelstein put it in their estimable piece in Wired magazine, this was just too much to stomach. “Frankly, we saw history repeating itself,” Microsoft’s head flack John Kelly told them. “We realized that we were going to have to speak up.”

Microsoft mobilized the army of lobbyists it had left over from its own Justice Department war and went to work, warning the feds of Google’s alarming market share, and the potential it had to abuse it. It also made new allies: Amazon (AMZN), AT&T (ATT), public interest groups, and the Association of National Advertisers. Eventually, thanks in part to Microsoft’s pressure, the feds killed Google’s deal with Yahoo. But it did something equally important along the way: It fed the growing perception, among lawmakers, regulators, and the public at large, that Google was a dangerous monopoly. By late 2009, Microsoft’s legion of lobbyists and lawyers were reportedly holding weekly “screw Google” meetings in Washington, D.C.

Recently we’ve seen the fruits of this labor. Three weeks ago, the European Commission declared that it was launching an inquiry into whether Google was using its massive search market share to damage three of its smaller competitors. Of the three complainants, one—an online price-comparison firm called Ciao—is owned by its archrival Microsoft. And a second—a similar price-comparison company known as Foundem—belongs to the Initiative for a Competitive Online Marketplace, a lobbying group that has complained about Google’s monopolistic practices the length and breadth of Europe. Who created the Initiative? You guessed it: Microsoft.

A few weeks before that, an attorney hired by Google to collect a few unpaid bills from an Ohio Internet firm received a startlingly aggressive antitrust countersuit. The lawyer handling the countersuit just happened to be Charles Rule, an outside lawyer who specializes in antitrust issues for Microsoft. As this and a second antitrust lawsuit against Google go into discovery, Rule will learn all sorts of interesting things about Google—and don’t think he’ll wipe his memory clean when he’s done.

There’s no denying this strategy has paid off. Because let’s face it: Google is effectively a monopoly. It has 65 percent of the American search market and at least 90 percent in France and Germany, where regulators have a much lower threshold for taking antitrust action. Google’s trust capital has also declined in another, not-insignificant segment: the investor class. Pension funds, venture capitalists, and 401(k) managers all had a chance to seriously cash in on the Yahoo deal. After Google played a role in killing it, Yahoo’s stock price dropped in half and has remained there ever since. These players know enough not to take it personally when Google brought out the long knives. But among these people, the days of pretending that the search giant just happens to make money on the path to saving the world are over.

“I hear this ‘Don’t Be Evil’ nonsense, and I’m like, c’mon,” says tech analyst Kim Caughey, whose Fort Pitt Capital Group has invested in Microsoft. “You’re kind of a wolf in sheep’s clothing. If you’re just going to behave according to the market, I can understand that. But touting themselves in this peace loving, free-search-for-everybody thing, that doesn’t obscure the fact that they were scooping up great gobs of market share. Don’t pretend you’re not like any other company trying to maximize profits.”

It’s entirely possible that Google knew that sooner or later, there would only be two players in the search market: Google and someone else. And that its goal was to push that day as far back as possible, keeping its competitors from joining forces just long enough to squeeze every last drop of profit before it faced a serious, consolidated rival. Opposing the first Microhoo iteration and toying with a Yahoo partnership bought Google two years of continued dominance, and that sounds pretty smart.

But consider this. In 2007, before the Microhoo deal broke to the surface, Google spent just $1.52 million on Beltway lobbyists. Last year, that figure rose to more than $4 million. Meanwhile, Microsoft’s lobbying expenditure dropped from $9 million to $6.72 million during the same period.

Some of these lobbying efforts are aggressive, of course, as the company tries to influence the Federal Communications Commission to tweak rules regarding broadband and the wireless spectrum, for example. But a huge chunk of that cash is dedicated to defensive lobbying, in which each company tries to convince the feds that it’s not a predatory trust. Which company has had to spend more and more lately?

Sooner or later, policymakers were going to think of Google as the New Borg. But by raising questions about who was really dominating the search market, the company catalyzed that process. Google provoked the excitable alpha dogs who run Microsoft, irritated investors, and called attention to its own supremacy. And it saved its worst enemy $44.6 billion.

All that for two more years of the status quo. In the years to come, Eric Schmidt and the boys may well look back on 2008 and ask, “What were we thinking?”