I must say that the original approach seems very limiting to me. It would basically not allow you to write anything that is
1) not implemented and
2) different from what anyone else, given the same stats and skills, would produce.
My #1 most hated thing in computer games is exactly this limitation to what the author(s) of the game foresaw or saw fit. That's why I much prefer P&P RPG.
In an MMORPG, people strive for originality and distinctness. This is being catered to by the extensive customisation that usually is provided. Were this not the case, one single set of clothing would suffice if it's stats could change.
Especially when you are starting to provide content, which is what you are trying to do when you write books ingame, it is important to not be limited by the game itself. Otherwise, it would be reduced to unlocking things that aren't even originating from you.
Literature should be ingame, as game mechanics, in form of library books, snail mail, bulletin boards, etc., while literacy should be left to the players. It is true that the vast majority of players will RP literate characters. It is possible that they simply take literacy for granted and the possibility of illiteracy never occured to them. It is also possible that they don't want to put up with the constraints of illiteracy, even though these are much less severe in some medieval setting that barely has any texts it relies on, than modern times where without text you aren't going anywhere (even literally, pun intended) most of the time.
However, this may be just one of the points where realism should be put on the back-burner for sake of enjoyment. Similar to allowing people to choose their skills and stats: being forced to RP something that you are not comfourtable with, or quite possibly not capable of, is inevitably doomed to result in poor RP at best, and continous frustration on average.
IOW, books and such should ideally be similar to the char description window. Obviously, they need to have a much higher standard than that in order to be put in a library - however, that is for the librarian to judge. I don't even see too many problems regarding appropriate content, because 1) noone is exposed to the content without choice and 2) it will be easy to track down the offender. It would be possible to add a "Flag as inappropriate" checkbox to the examination window, as well as a "PG rated" mark.
Edit: I have seen some games using forms of distortion (usually removing / adding letters) to implement being drunk or daft. However this, while being fun initially, IMO has only limited success in the long run. Also, it doesn't capture the full spectrum, since for example even a daft person can be able to furmulate decently, even on paper. Likewise, someone highly intelligent can be unable to write properly. Granted, a mix of: rhetoric, literacy and intelligence could account for this, but still there would not be much individualism (be it the char's choice, upbringing, or both). If one were to apply this scheme to books, though, one would also need to apply it to general chat.