(MONEY Magazine) – The musky, noisy bazaar in the northern Iraqi city of Erbil winds its way in a labyrinth around an ancient castle. This commercial center dates back to the beginnings of Western civilization. From the 1960s to 1991, life and commerce wilted here under the rule of the Baath Party and Saddam Hussein. But just as the U.S. ponders a war to oust Saddam, the world has discovered in Northern Iraq--or Kurdistan, as the locals call it--a Switzerland-size free-market democracy of 3.5 million people that has flowered under his nose.

The region was laid to ruin in 1991, when Saddam crushed the Kurdish rebellion after the Gulf War. But the U.S.- and British-imposed no-fly zone has mostly prevented soldiers from returning, while the U.N.'s food-for-oil program has funneled 13% of Iraq's oil revenue to the region.

The results are striking. Erbil now has competing cell-phone providers, Internet cafes and brightly lit supermarkets. Mercedes and BMWs zip by on freshly paved roads. Construction goes on everywhere. "Hot here is every idea that fills a gap in the market," says Abdul Salaam Barwari, a computer engineer who returned from Austria two years ago and now runs a newspaper. Ordinary Kurds as well as entrepreneurs are benefiting: The average salary here is $50 a month vs. $3 in the rest of Iraq.

Still, Saddam's troops are just 20 minutes from Erbil. Kurds fear that all they've built could vanish in a few hours, says Jalal Jonroy, a screenwriter who came back to visit from New York City last year. "It's like a beautiful dream that you can wake up from at any moment." --Borzou Daragahi