This is a tested working method of installing and running Windows XP from a flash drive.
I have done this but it has just one little problem. Every time you plug in a new USB device, Windows will give the "This driver has not passed Microsoft Logo testing, Do you want to continue?" warning. It only shows up once per new device and does not affect the operation of Windows, so it's just a little nag that you'll get once in awhile.
This allows Window to be installed and run with no other drives of any kind.