Liechtenstein remained neutral throughout World War II, and its neutrality was not violated by any of its combatants. The country sought to align itself as closely as possible to Switzerland in hopes of retaining this neutrality, while also maintaining steady relations with Nazi Germany. German diaspora in Liechtenstein formed a local group of the Nazi Party/Foreign Organization. Additionally, Liechtenstein Nazis formed the German National Movement in Liechtenstein (VDBL), which sought the country's annexation into Germany.

Liechtenstein has maintained a policy of permanent neutrality since 1868, remaining neutral throughout World War I. However, until the end of the war, it was closely tied to Austria-Hungary due to the customs union that had existed between the two countries since 1852 and was sympathetic to the Central Powers. As the war dragged on, Liechtenstein faced economic devastation and food shortages as a result of the lack of natural resources, which increased smuggling into the country significantly and forced the country to reduce its reliance on Austria-Hungary and seek closer economic ties with Switzerland. By 1916 all food deliveries from Austria-Hungary had ceased, which forced Liechtenstein to seek closer ties with Switzerland in order to ensure food deliveries continued.

In 1919, following the dissolution of Austria-Hungary, the Liechtenstein government could no longer rely on Austria to fulfil their monetary and diplomatic needs. Liechtenstein and Switzerland signed a treaty under which Switzerland assumed the representation of Liechtenstein's interests at the diplomatic and consular level in countries where it maintains a representation and Liechtenstein does not. Liechtenstein adopted the Swiss franc in 1920 and the two countries entered a customs union in 1924. In 1921, a new constitution was introduced that established the rule of partial parliamentary democracy mixed with that of constitutional monarchy, much of which was loosely based on the Swiss Federal Constitution.

Like most other countries at the time, Liechtenstein was subject to a rise in unemployment, decline in agriculture and collapse in industry as a result of the Great Depression starting from 1929. Throughout the 1930s the country was dominated by the Progressive Citizens' Party, led by prime minister Josef Hoop, who had been in office since 1928. Starting from 1933, Liechtenstein was faced with external and internal challenges from Nazi elements, notably the Rotter kidnapping and 1937 Liechtenstein spy affair. It also saw the rise of authoritarian elements within the country, primarily the Liechtenstein Homeland Service, which moved towards that of Nazism shortly after its founding in 1933, and then merged with the Christian-Social People's Party in 1936 to form the Patriotic Union. On 30 March 1938, in the wake of the Anschluss of Austria and under the initiative of Franz Joseph II, the Progressive Citizens' Party and opposition Patriotic Union (led by Otto Schaedler) formed a coalition government. In the subsequent 1939 Liechtenstein general election the two parties assigned a roughly equal number of seats in the Landtag.

Around the same time as the coalition was made Nazi elements within Liechtenstein formed the German National Movement in Liechtenstein (VDBL), which sought Liechtenstein's annexation into Nazi Germany. Though there were plans for the Volksdeutsche Mittelstelle (an agency of the Nazi Party) to fund the party to be democratically elected to power in Liechtenstein with the goal of the eventual annexation of the country into Germany, they were blocked by Adolf Hitler personally due to his desire not to complicate relations with Switzerland. From 2 to 3 March 1939, Franz Josef, Hoop and Alois Vogt paid an official visit to Berlin where they met Hitler and Joachim von Ribbentrop, where they discussed safeguarding Liechtenstein's independence and neutrality while maintaining good relations. Hitler met Franz Joseph II and Hoop for a thirty-minute meeting, but no negotiations occurred. Franz Joseph II later reminisced on the visit and stated that Hitler showed little interest in them and that it only took place to "flatter Hitler's ego".

The country came under threat in the 1939 Liechtenstein putsch. The plan was for members of the VDBL to march on Vaduz and attempt to seize control of the government, which was hoped would cause clashes between them and the government. German troops from Feldkirch would then move into Liechtenstein in response to a call for help and incorporate the country into Germany. The plan failed however, as they were stopped by opponents, and most VDBL members were arrested or fled. No German invasion took place as it was blocked by Hitler's orders following intervention by Vogt. It is not exactly known why Hitler decided to not intervene in the coup, though it has been speculated that he had little interest in Liechtenstein, and that he did not want to provoke a war with Switzerland. The attempted coup led to the Liechtenstein Loyalty Association, a nonpartisan organisation designed to oppose the actions of the VDBL that was formed earlier in the year, to heighten its operations and launch a signature campaign reaffirming Liechtenstein's independence and loyalty to the prince, which gained 2492 signatures, representing 95% of the country's eligible voters.

Liechtenstein declared its neutrality on 30 August 1939 via Swiss representatives. When the war broke out, Hoop's government was given extensive powers to manage the Liechtenstein economy during the war and it applied several Swiss war economy laws to Liechtenstein. By doing this, Liechtenstein achieved de facto inclusion in the Swiss national supply. However, Swiss distrust of Liechtenstein's official stance grew, primarily due to the actions of the VDBL, and demanded that Hoop's government publicly declared its allegiance to Switzerland, which it did on 5 November 1940. In exchange, Switzerland agreed to a new alien police agreement that allowed Liechtenstein workers to freely travel and work in Switzerland from 1941. Though Switzerland protected Liechtenstein's sovereignty throughout the war, Liechtenstein was not planned to be directly defended by Switzerland in the event of a German invasion.

Hoop's government considered friendly, non-binding, non-provocative diplomacy to be appropriate towards Nazi Germany, supplemented by courtesy gestures. In December 1940, during a lecture in Stuttgart, Hoop showed respect for the German armies. Nazi Party member Hermann E. Sieger (who had been Hoop's primary German contact since 1933) acted as an intermediate between Hoop and the German government while also supporting Hoop's efforts to retain Liechtenstein's independence. Franz Joseph II periodically sent congratulatory letters to Hitler, such as New Year's messages and for the thwarting of the 20 July plot, which he briefly replied. These letters were considered an indication of Hitler's recognition of Liechtenstein's sovereignty. However, Liechtenstein was intended to be invaded and annexed by Nazi Germany alongside Switzerland in Operation Tannenbaum.