I prefer a "free market" solution of the problem.
If you want to stop a democracy from building huge army in a peace time, don't put some artificial penalties in the game. Just provide the player with the choice- to use my resources for a big army or to use them for the economy and research.
Personally I can not see any option but to put in some penalties in there could be various different flavors though:
1) Reduce IC before war (like HOI2)
2) Limit the number of troops they can build during peace. And so force them to use it for "economy". (probably through reduced manpower)
3) Make troops more expensive to produce during peace.
4) Force them to spend IC on "consumer goods" during peace time.
5) Make producing large numbers of troops politically costly.
I guess with your "free market" approach you are thinking more along the lines of 3) and 5)