I just installed windows 7 on a machine last night using an external usb hard drive (same process as a flash drive)
Worked like a charm.
It was a tricky process to get working for a thousand different reasons. Went through about 5 different attempts a few months ago before I got it working. Good luck!
If you run into trouble, I'll try and assist based on that experience.
Actually, it should be easier if you're doing XP. A lot of the hurdles were windows 7 specific.