Yes, in fact that is exactly what happens. Many of the people at Google who are level 3/4 SWE's (about 70% of engineers are at that rank, it is considered a junior level) feel that they are under-utilized, and there is a lot of angst at that level. Those people would probably have more important/impactful roles at other companies. Some do in fact leave for other companies, but many end up tolerating the situation as other aspects of working at Google compensate (stable, brand name, perks, etc.).
As for why management continues this interview process: probably because they can. Lots of people apply to Google, and they have a high acceptance rate for offers extended. There is also a historical aspect to it: "we have hired this way in the past, and it worked, so why change it?" and fear: "if we lower our standards, the company culture is at risk" The problem of low-level SWE discontent showed up on management's radar around the time that I left, so I'm not sure if they are doing things to change that.
As for why management continues this interview process: probably because they can. Lots of people apply to Google, and they have a high acceptance rate for offers extended. There is also a historical aspect to it: "we have hired this way in the past, and it worked, so why change it?" and fear: "if we lower our standards, the company culture is at risk" The problem of low-level SWE discontent showed up on management's radar around the time that I left, so I'm not sure if they are doing things to change that.