The Lag Generator (which in retrospect should probably have been called a Slew Limiter) simply smooths the changes in its input, be it an audio or modulation signal. The amount of smoothing is controlled by the Lag parameter: a higher value produces a smoother signal.
It's probably easier to hear this than to explain it, and also an easier concept to grasp with a modulation rather than an audio signal: create a new preset, route a fairly slow square LFO to the Lag Generator, and route the Lag Generator's output to a Low Pass Filter's cutoff, with say 100% modulation depth. Now, listen to the changes as you increase the Lag: at low values, the filter jumps between the high and low states of the LFO; as the lag increases, the changes are smoothed and the filter will glide between said states.