Where does Google's $1.65 billion YouTube acquisition leave Microsoft? The question is particularly interesting in light of reports that the Redmond company was one of those that talked with YouTube about a possible deal.

Asked about those reports today, Microsoft didn't precisely confirm them, but didn't directly deny them, either. In a statement, the company said it "evaluated acquiring this type of technology several months ago" but decided that building its own video-sharing service would be "a more cost-effective way to compete in this new space." The company launched the test of its Soapbox service last month.

Note especially the phrase "a more cost-effective way to compete." Of course, Microsoft wouldn't be so blunt as to say, "We think they paid too much," at least not in a public statement. But the situation brings to mind a comment made by Microsoft CEO Steve Ballmer at the company's annual meeting with financial analysts this summer. Asked about Microsoft's acquisition strategy, he recalled considering a $500 million-plus deal involving a company with less than $20 million in revenue, in existence for about one to one-and-a-half years. As it happens, that time frame would fit YouTube, founded in February 2005.

Microsoft's nascent YouTube alternative, Soapbox. (Click for larger screenshot.)

But regardless of whether YouTube was the anonymous company behind that particular example, Ballmer's subsequent explanation provided some insight into how Microsoft is approaching these kinds of deals nowadays. He told the analysts: "You have to decide which of these things really have monetizable user bases, because there are plenty of ways to buy activity without necessarily augmenting, in a substantive way, your position."

In the case of YouTube, the question of liability for copyright violations no doubt would have played into the analysis, as well. Before today's acquisition announcement, Google and YouTube announced a series of deals with content providers that are seen as a step toward alleviating that problem.

YouTube's prospects for profitability have been open to debate. But the site's traffic rose to 34 million unique visitors in August, according to Nielsen NetRatings. Joining with Google positions YouTube to explore new ways of generating advertising revenue. And Google is paying for the deal entirely in stock, not cash.

Whatever your opinion of the $1.65 billion valuation, there's no disputing the fact that the deal brings together one of Microsoft's biggest online rivals with the largest player in one of the fastest-growing areas of the Internet. It will be interesting to see how the combination of the two changes the competitive landscape for the company in the long run.

Update: Along the same lines, BusinessWeek looks at the YouTube deal's implications for Google's primary competitors. From the section on Microsoft:

Microsoft CEO Steve Ballmer, meeting with BusinessWeek editors Oct. 9, said Google could emerge from the YouTube deal an even stronger rival. If Google can work out a good advertising model with YouTube, he said, it makes Google a stronger competitor to Microsoft. It will have a larger share of the growing online ad market, and can use the cash to create more products like the free online spreadsheet software, calendars, and word processors it already offers. But Ballmer says Microsoft has a long-term strategy, not to mention a history of coming from behind to overtake rivals such as Netscape, the early leader in the browser market. "We're very long-term. We've got a stick-to-it-iveness, a tenaciousness that I would argue is unmatched," he said.