Yes, actually, it is. That's the whole point.
The economy will stagnate. Eventually the entire portfolio the room holds will be money losing companies, burning up the country's capital.
The half of the room who are active investors contribute greatly to the economy's long term growth. They could either have negative long run returns as passive investors, or positive long run returns that are less than passive investors.
Index funds are weighted by capitalization. So whether GM's capitalization goes up or not is actually irrelevant: what's relevant is the ratio of its capitalization to the size of the total capitalization of all companies in the market, and how that changes.
Setting that point aside, here's some basic math that shows why this analysis is completely wrong and why GM's market cap will go down. Let's say today, I am the CEO of GM, and I issued 1 million new shares, bringing the total up to 1 Billion outstanding shares. I dump them on the market, when the price was $50. The price drops some amount, because shares are being sold.
How much money did I, as CEO of GM, raise? At most $50 million
How much could market cap possibly have gone up? Exactly the amount that was raised: at most $50 million
How much could market cap possibly have gone down? Drop in stock price * 1 Billion
So market cap increase is precisely equal to the amount of capital provided by investors, which is finite and won't run away into a vicious cycle as suggested by the poster. Market cap decrease can be... well... 100%, all the way to zero. And the more shares issued, the more downward pressure on market cap... as the effect of crossing the bid-ask spread on market capitalization gets amplified.
I'm sorry, that's an invalid assumption. Especially in a world with only passive investors.
GM has been losing $1 billion a quarter for 10 quarters. GM's stock price is $30 as it has been since 10 quarters ago, market capitalisation $40B. It is running out of cash building unprofitable products. The underwriter calls various index funds, telling them there will be a capital raising of $10B, at $28 per share, representing a ~5% discount, and as a result of that, GM's weighting in the index is going to be re-weighted upwards at the next index balance in three weeks, so they might as well sell other (more productive) stocks, which will be weighted downwards, and buy GM at a discount. The capital raising is "oversubscribed" because of this arbitrage opportunity. As a result of the discount, the stock price of GM falls from $30 to $29.50 ($2 times by roughly 25%). GM's stock price falls 0.16% per quarter, and can sustain this rate indefinitely because of passive investors.
In a stock market with active investors, GM's fall in stock price would be a lot more than 50 cents.
Passive investors represent inertia that will keep the current ratios of market capitalisation between companies listed on the stock exchange constant, even if those ratios are suboptimal economically. As a result of the stunted capital allocation, the economy will begin to shrink, over the long run, as it continues to support unprofitable companies by depressing the share prices of the more productive companies, since, ironically, those more productive companies raise much less money than the unprofitable ones, and those capital raisings funded by selling the other companies that aren't raising money.
It's like going into a casino and arguing that the casino is losing because you see one guy hit a jackpot on the slot machine.
But you aren't. That's who he was speaking to and speaking about. Average investors.