It's an artificial limit that keeps up the quality. It's the reason nightclubs have bouncers.

There are a lot of great PhD students who will never be able to get a faculty position. It bears notice that the number of faculty spots has being going down for over a decade.

Exactly.

There's no shortage of people who can teach, there is only a shortage of a willingness to pay them to do so.

Your popularity goes down if too many of your classes are taught by PhD students and post docs. Overhead is brutal, and research grants are limited, so hiring more faculty is tough. If they just hire enough professors to satisfy demand, they would be on the hook for paying most of their salaries since they are unlikely to get funding. Hiring a bunch of pure teaching faculty is a no go since that turns the flag ship into a less popular non-research university.

In the humanities at least, tenure-track hiring numbers are down about 50% from pre-2008 era, while the supply of humanity PhDs is broadly stable.

The problem is that the university departments are less willing to hire the faculty that they once did, and that largely comes down to university administrations having decided that paying for anything non-STEM (and non-sports, I guess) isn't worth it anymore.

Research universities don’t pay most of their faculty’s paychecks, research grants do. Research funding agencies are more to blame for this than universities, and it also reflects more STEM demand in the job market, why encourage creating a bunch of graduates who can’t get jobs?