[Manwe Sulimo]

If you think about it in a more real-worldish view, it makes sense. The Third Age was like the Dark Ages--approximately AD 500-1100. During that time, there wasn't a great deal of creative fiction circulating around the world (or Europe, at least, which ME is based on). Save for some wandering minstrels (elves) and great myths (real world: dragons and sea monsters, great knights; ME: the same, but it's real), there really wasn't fiction. There was really no need, and no means of doing it. The printing press had not yet been invented, and people lived by working all the time. Unless very old (something that didn't happen often), people didn't have the time to make such stories up.

In Middle-earth, the same problems arise, but at the same time there is a reason unique to ME: anything a myth would be made of, it already exists. As Annunfuiniel said, they already had mythology in their own history. They didn't have to make up deities; they knew them personally (the older elves, at least). Exotic creatures like dwarves, dragons, and sea monsters all existed. Now I'm not saying that hobbits or men couldn't have created even wilder stories; it's just that all myths have a basis in fact, and real things in ME were real to the extreme. You couldn't exaggerate things much farther than they really were; hence, there were no tales that couldn't be confirmed one way or another.

There were probably some hand-written novels in the Shire; fictional stories of adventure written by some lazy hobbit. However, there would only be a few copies (printing press issue again). Bilbo did receive some books from the Elves (three, I think, including the Quenta). But these weren't fiction.

Now I'm starting to ramble.