There's a thousand different ways to deal with this situation, and in any case, whether you agree with the fiancee's approach or not, this particular consequence isn't likely to turn the young lady into a monster. She'll likely turn out a perfectly presentable human being in the long run.
That said...
"She would take her out on the playground and call her names, and tell her she was a slob and tell her she dressed like a sleaze." I don't see the clothes as the primary issue here. The real issue is the meanness and cruelty and name calling and targeted harassment. I don't care why it's happening, there's no excuse and it's going to stop.
Making my daughter dress in "ugly" clothes (and I don't think it matters where they come from) wouldn't teach her a darn thing about how to be kind to people you might not like, for any reason. It won't teach her that no one deserves to be bullied (after all, aren't we ensuring that she's going to be bullied because we feel she deserves it?). It won't teach her to avoid people who irritate her. It won't teach her not to be destructive in her interactions with others. All it will teach her is that clothes matter, and if she doesn't want this to happen again, she'd best keep her mouth zipped. It also teaches her that bullying is sometimes justified.
As a kid who was bullied viciously throughout elementary and middle school, I can tell you that making it about the clothes only makes things worse. It means that, because I wore hand-me-downs, I deserved to be bullied. Punishing my bullies only lead to glares and hissed insults and anonymous attacks. They blamed me for their punishment, and they learned to be more careful about getting caught in the future. They didn't stop.
In this case, this is a lesson that has to be taught, not through a single grandstand move like making the kid wear ugly clothes for a week, but through months and years of supervision, coaching, conversation, role-playing and frequent opportunities to build empathy for others, possibly through volunteering or charitable work. I'm not saying tie it all to this one incident. I'm saying, if you have a child who is physically weak, you make physical activity part of your daily life. If you have a child who is deficient in empathy and kindness, then you make building empathy and kindness part of your regular routine. Live it, don't just lecture about it.
Basically, everyone has their own approach to raising kids, and most approaches work perfectly adequately. This wouldn't have been mine, though.
In Canada, the Supreme Court ruled that teachers couldn't use physical force in 2004. (And most schools had stopped using it decades before.)
