Both stories are based on lies which show the extent to which those who believe them are unable or unwilling to face up to reality.
Through his cops-and-robbers game with Bert, a neighborhood kid, Joe has encouraged the false story that he is actually a chief of police with a jail in his basement. He tells Bert that he locks up criminals in his jail, and Bert believes him until Kate tells him that it's not true.
Bert wants to believe in the story because it corresponds to his naive understanding of the world in which crime doesn't pay, and the bad guys always get their just deserts. In the real world, however, it's different; Joe Keller is actually one of the bad guys and it's his dark secrets that he keeps hidden away, not criminals.
It's somewhat ironic that Kate of all people should disabuse Bert of his belief in Joe's story, for she too believes in something that isn't true: that her son Larry's still alive. Though her story is more plausible than Bert's, it still has the same foundation in truth: none whatsoever. Larry isn't coming home, just as no criminals will ever be slung into Joe's own private jail.
Bert's belief in Joe's tall story is related to his youth and naivety. Kate, on the other hand, is a fully-grown adult, way too old for fairy stories. And yet her firm belief that Larry's alive and well and ready to walk through the door at any moment is absolutely essential to her well-being; she needs to cling on to hope if she's to avoid falling to pieces. Her story is therefore much more vital than Bert's.