Defence chiefs had to cut projects for helicopters, warships and Nimrod spy planes after Gordon Brown "guillotined" their budget, the Iraq inquiry was told yesterday.
A former top civil servant at the Ministry of Defence (MoD) yesterday spoke of the "crisis period" when Mr Brown as Chancellor slashed military spending six months after the March 2003 invasion of Iraq.
The numbers of Armed Forces personnel and civil servants were also reduced.
Sir Kevin Tebbit, who was MoD permanent secretary from 1998 to 2005, stressed defence chiefs saved resources needed for Iraq but admitted the cuts had a long-term impact.
He said: "I was running essentially a crisis budget rather than one with sufficient resources to be able to plan as coherently, as well for the long term, as we would have liked."
The problem arose when the Treasury realised that new Whitehall accounting rules introduced in 2002 to drive down costs had actually allowed the MoD to increase spending, the inquiry heard.
Sir Kevin said: "By the summer of 2003, after as it were the Iraq operation, the Treasury felt that we were using far too much cash. And in September 2003, the Chancellor of the day instituted a complete guillotine on our settlement."
He defended his Department's spending, saying an investigation by independent consultants concluded the MoD's budget was within Treasury rules.
And he hit back at the evidence of Treasury permanent secretary Sir Nicholas Macpherson that military spending was increasing by nine per cent a year when Mr Brown stepped in.
Sir Kevin pointed out that in 2002 the Department for Transport's budget increased by 12 per cent and the Department for International Development's by eight per cent
"It's not as if it were completely unreasonable for the Ministry of Defence to be behaving in the way it did," he said.
The MoD managed to claw back some money in the 2004 budget but only after hard negotiations with the Treasury that concluded just six hours before the deadline, the inquiry heard.
The inquiry heard earlier this week that all of Britain's senior military chiefs threatened to resign in protest at the cuts.
CIA warning of Al-qaida attack
Terror group al-Qaida is expected to attempt an attack on America in the next three to six months, intelligence chiefs have told the US Congress.
Operatives were being sent to the US to carry out new attacks from
inside the country, including "clean" recruits with no trail of terrorist contacts, CIA director Leon Panetta said.
The chilling warning comes it emerged Christmas Day airline attack suspect Umar Farouk Abdulmutallab was co-operating with investigators.
Al-Qaida is also inspiring home-grown extremists to trigger violence on their own, Mr Panetta said.
The annual assessment of terror threats provided no startling new trends but increased growing concerns since the airline attack.