Fear vs. Reflection...How Best to Raise Our Children

There is a debate raging inside my head about how best to raise my children.  The little angel sitting on my right shoulder keeps telling me to raise them to be self-reflective, caring citizens who think about their actions and make choices based on a deep seated set of ethics.  The fat, lazy couch potato devil on my left shoulder says that I should teach them to follow the rules blindly and out of fear of whatever consequences my evil brain may cook up.
On one hand, I really like the idea that my children will make choices according to a set of ethics and a feeling of empowerment.  On the other hand, I want them to just automatically do what I say without questioning.
Don't get me wrong-this does not apply to all issues.  Safety issues are not negotiable.  There is not any ethical middle ground to running into the street.  This applies to questions like should I be honest?  Do I hit back?  Do I share with my friends?  For the most part, Olivia seems to understand that you share with friends because it makes you feel good and makes them feel good and that's one way that you show people that you care about them.  However, she is only four and there is only a certain amount of self-reflection that is possible.
When the situation presents itself, however, I generally try to talk with her about what she thinks she should do in a situation and why, and what may be some alternatives.  The problem with this route, though, is that she now is negotiating with me and is really good at it!  It is a little scary, how logical she can be and how quickly she can put together an argument.
So, now I think that I am going to have to go the route that my mom ended up going which is a combination of reflection first then fear.  She had two tools in her arsenal and they were good ones.
1.  She told us that she had spies all over the neighborhood and they would be watching us.  Therefore, she would always know what was going on.  The scariest thing was, it was true!  One day my sister crossed the road (jay walked) with no one in the road and no one around.  When she walked into the house my mother called from work and told her that she knew that Steph had crossed the street...and not at the light!  We were amazed and terrified by her power!  For years to come, and still to this day, when faced with a choice that could be a bad one I think a. does this seem like the right thing to do? and b. if not, is it worth getting caught and getting in trouble?
2.  She had a remote that would beep when a button was pushed.  It had a small speaker and nothing else on it.  She told us it was a lie detector and would point it at us when she asked us questions.  We believed.

So, when my girls grow up, I hope they feel the same way about me that I feel about my mom.  I hope, when they remember me, they think "She taught me right from wrong, and when all else failed, I sometimes made better choices because I was afraid of the wrath that would come down on me."