Today Sir Fred Goodwin is perhaps the most vilified man in Britain, in the light of his refusal to give up any of his £690,000 annual pension from the Royal Bank of Scotland. His defenders are mute, and I am not one of them. But the implications of what ministers may now do about this could inflict enormous harm on the British economy, a zillion times greater than Sir Fred's £16 million pension pot.

The Government is furious that the former chief executive of RBS almost certainly has a rock-solid contractual right to the money. The Prime Minister has been harrumphing about taking legal advice on a possible clawback, and Harriet Harman, a former law officer who should know better, has said that it will not stand. Old Labour warhorses are saying that ministers should use their majority shareholding to direct the RBS board to break Sir Fred's severance contract. The media is hot with the notion of a special Act of Parliament to extinguish his contractual rights.

Unless it has the effect of persuading the man voluntarily to give up the money, this is all dangerous sabre-rattling. Ministers cannot direct RBS to break this contract. The Government is obliged to uphold the law, including the law of contract, and the RBS board would be perfectly entitled to refuse to comply. Even if the bank were to withhold the money, its former chief executive could sue and would win. Contracts are binding on the parties to them, yes, even if you are Her Majesty's Government. How inconvenient.

Legislating wouldn't work either. The European Convention on Human Rights says that a state cannot expropriate private property without paying adequate compensation. Even if a British court were to enforce this special legislation, Sir Fred would win in Strasbourg.

Trying to legislate to annul an inconvenient contract binding on the State (or a state-owned bank) would do massive harm to Britain. What company in its right mind would place reliance on a contract with a Government that is prepared, after the contract has been signed, to use its legislative pen to strike out the clauses it later decides that it doesn't like? If we go down this route we get close to the status of developing countries, such as as former Soviet republics, where foreign private companies need special protection against political interference in their contracts with host governments. Their technique is usually to set up enforcement of the contract in a neutral third country, with direct recourse against the foreign-held assets of the state in question. Is that really where the British Government wants to take us?

Unfortunately, the present Government has form. In 2001, the Government's No1 hate figure then was Railtrack. Ministers decided it had to be taken out, and a cunning plan was devised in the Treasury to euthanase the company and get its assets for nothing. To do this, in the words of Mr Brown's closest adviser then, Shriti (now Baroness) Vadera, they decided to “engineer the solution through insolvency”. If they could persuade the High Court that Railtrack was insolvent, the plan would work.

But Railtrack was not insolvent, because of indemnity clauses in franchise contracts between the State and the private railway companies. Those companies had separate contracts with Railtrack, under which they paid track access charges. If the politically independent Rail Regulator increased the sums the franchisees paid Railtrack, they had back-to-back contractual rights to get the extra money from the State. Very awkward.

Ministers knew that if they simply refused to pay, the franchisees would sue and win. And so the Government decided that it would neutralise these inconvenient contractual indemnities. Emergency legislation was drafted to enable ministers to order the regulator not to increase Railtrack's income. The indemnities in the franchises would, therefore, never be triggered, and ministers would not have to pay out. Railtrack would be bust.

But hold on, the regulator might not acquiesce. The legislation would be extremely controversial. It couldn't be passed quickly enough to stop him raising Railtrack's charges before the door was bolted. Just before the Government revealed this supposed fait accompli to me, Shriti Vadera anxiously warned her colleagues that if I were to resist, “it could make the compensation claim huge”.

When I was told at the very last minute about their great scheme, I was struck not only by the fact that the Government was prepared to do this, but by the information that it had been cleared by both the Prime Minister and the Chancellor.

Despite these very improper threats, I told Railtrack I was prepared to use my powers and race the legislation to the finishing post. But Railtrack had given up, and didn't fight back. The legislation was ready, but it wasn't used. Railtrack regarded the threat of it as enough, and went quietly into that long dark night. Threatening companies with legislation to extinguish their contractual rights was obviously a desperately clever thing, and it was kept for the next time some enemy of the State with an inconvenient contract had to be dealt with.

On October 24, 2005, having repeatedly insisted that the independence of the economic regulator for the railways was sacrosanct, Alistair Darling tabled a Commons motion congratulating the Government on the legislative threats it had made to me. So now we know what he thinks of contracts that government later wishes it hadn't signed. The damage caused by the Government's handling of Railtrack was severe, and it took years for confidence to recover.

If Ms Harman's harangues are to be translated into special legislation to reduce the value of one wealthy banker's severance contract in an act of political vengeance, we will revisit the place of Third World governments whose promise is suspect. Are the word of the State, the sanctity of contract and the rule of law really worth so little that they should be undermined in this way to pursue a political vendetta? Sir Fred Goodwin can afford to give up the money, and perhaps he will, but the British Government will pay an exponentially higher price if it tries to legislate it out of his grasp.

Tom Winsor was the Rail Regulator, 1999-2004

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