No, you certainly can boot from an external DVD--I've used an old Apple-pull DVD-RAM drive in a firewire case to install on G4 towers with no DVD drive.
...but I'm not sure if you can boot from a USB drive. I don't think so, although I don't have any way of trying it.
I THINK there was a tutorial somewhere for getting the OS from a DVD onto a functioning CD, but that might be faulty memory on my part.
Installing on an external hard drive then cloning to the internal would be another option, but again that would require being able to startup from USB, so if that worked, so would the DVD.
If your time is not money (or you like goofing around), the cheapest way to do this is just to rip open the computer and either plug a DVD drive temporarily into the optical drive bus, or just pull the hard drive and install it in another computer, install OSX on that, then put it back in. It's a monster hassle with those old iMacs, but it works.
It's funny, I thought everything after the first gen of slot-load iMacs came with firewire... guess my memory isn't as good as I thought.
