Krishna identifies the core problem. The entire world is so absorbed in the play of the three gunas — clarity, restlessness, and dullness — that it cannot see the one who stands beyond all three. The imperishable Lord remains unrecognized.
It is like a child lost in a dream. The dream feels so real — its characters, its dangers, its pleasures — that the child forgets he is simply asleep. The three gunas create a similar spell. Caught up in their constant shifting, people lose sight of the unchanging reality behind it all.
But this shloka is not the end of the conversation. It states the problem, and the very next shloka provides the way out. Those who cross this delusion find what they are looking for.