Myth, myth! Yeth?

Once you accept that the Torah is mostly mythology, the next question is, now what? And to some degree, I think the answer hinges partially on how the ancients themselves approached myth. I'm no expert on myth, but I have heard the following three approaches:

1. Of course the ancients believed their mythologies. Duh!

2. Of course the ancients didn't believe their mythologies. Duh!

3. The ancients did not distinguish between myth and reality like we do. They had a whole different conception. Therefore the question is invalid.

Nobody ever seems to bring any real proofs for the above approaches. And I think that proof may be impossible, how could you prove one way or another? And of course it could vary from culture to culture or myth to myth.

There's an interesting book that I read a while back, When They Severed Earth From Sky, about ancient myth. The argument there was that myths were memorable ways in which ancients encoded important information. For example, rather than tell their kids that a certain mountain was prone to volcanic eruptions, they invented a myth about a devil with long red hair (lava flows) that inhabited the mountain. IS that true? I don't know.

I started reading Michael Fishbane's book, Biblical Myth and Rabbinic Mythmaking, but it wasn't what I thought it would be. Rather than an extended exposition of how and why Chazal made up myths, instead it focuses on particular myths, e.g. Rahab the sea monster. A good book, but it didn't answer the question.

And what is the question exactly? I think the key question is - Did Chazal themselves believe their own myths? Did they actually believe that Moshe sat in on Rabbi Akiva's shiur? Did they really believe in literal TMS? I wish I knew the answer to this question.