You just invented Reddit. The same thing will always happen: you say "communities should moderate themselves" and then you get "communities" that scream that 'libtards' need to be murdered, etc etc etc.. So then what?
The difference is that each instance is a completely separate entity. They live or die on their own. They have to secure their own hosting, figure out their own revenue stream, and deal with law enforcement on their own. It's reddit minus reddit.
The main difference with mastodon is that there isn't just one server hosting all of the material ; you can create your own mastodon instance, and likewise, if a hateful/illegal mastodon instance is found, people can avoid it and/or law enforcement can find it and squash it.
It's more analogous to email and shutting down an email server than shutting down reddit.
Wash, rinse, repeat.