I think this is inspired by real life.
Consider that where I live — the island of Ireland — was once a habitat for elk, wolves, wild cows and many species of deer.
Over the last thousands of years they have been killed off, or couldn't adapt to environmental changes.
The wolves were common in Ireland in the 17th century (see Wolves in Ireland) and my grandfather once dug up a partial antler from Great Irish Elk in a peat bog.
These creatures no longer exist, but occasionally their remains still come to light.
Imagine a farmer some hundreds of years ago finding the skeletal remains of a great Irish Elk
]... and wondering at the size of it.
For me it's simple extrapolation that people find the remains of large animals, or fossils of them, and see that those animals no longer exist in their area.
Add to that the tall tales, the man who survives a wolf attack, it was never a small wolf, like the fish that got away it's size will grow each time the story is told, until it's the size of the dire wolves of old come again.
Fathers, bringing their sons wolf hunting, try to put a bit of heart in the boys by telling them "these wolves you get these days, they're nothing like the wolves we got when I were young, sure my grand father killed a wolf taller than he was with nothing but a stone knife and his own bare hands!"
Also, we all know that our fathers, and their fathers had it harder in their day that we do... though they were happier then, even though they were poor.
All of these things add to the impression that the world has diminished from how it was in the days of our ancestors.
Further reading of Dragon (Wikipedia) has unearthed (emphasis mine)
Nonetheless, scholars dispute where the idea of a dragon originates
from and a wide variety of theories have been proposed. In his
book An Instinct for Dragons (2000), anthropologist David E. Jones
suggests a hypothesis that humans, just like monkeys, have inherited
instinctive reactions to snakes, large cats, and birds of prey. He
cites a study which found that approximately 39 people in a hundred
are afraid of snakes and notes that fear of snakes is especially
prominent in children, even in areas where snakes are rare. The
earliest attested dragons all resemble snakes or bear snakelike
attributes. Jones therefore concludes that the reason why dragons
appear in nearly all cultures is because of humans' innate fear of
snakes and other animals that were major predators of humans' primate
ancestors. Dragons are usually said to reside in "dank caves, deep
pools, wild mountain reaches, sea bottoms, haunted forests", all
places which would have been fraught with danger for early human
In her book The First Fossil Hunters: Dinosaurs, Mammoths, and Myth in
Greek and Roman Times (2000), Adrienne Mayor argues that some stories
of dragons may have been inspired by ancient discoveries of fossils
belonging to dinosaurs and other prehistoric animals. She argues
that the dragon lore of northern India may have been inspired by
"observations of oversized, extraordinary bones in the fossilbeds of
the Siwalik Hills below the Himalayas" and that ancient Greek
artistic depictions of the Monster of Troy may have been influenced by
fossils of Samotherium, an extinct species of giraffe whose fossils
are common in the Mediterranean region. In China, a region where
fossils of large prehistoric animals are common, these remains are
frequently identified as "dragon bones" and are commonly used in
Chinese traditional medicine. Mayor, however, is careful to point
out that not all stories of dragons and giants are inspired by
fossils and notes that Scandinavia has many stories of dragons and
sea monsters, but has long "been considered barren of large fossils